ASSURED GUARANTY LTD - Annual Report: 2014 (Form 10-K)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
____________________________________________________________________________
FORM 10-K
ý | ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
For the fiscal year ended December 31, 2014
Or
o | 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 001-32141
ASSURED GUARANTY LTD.
(Exact name of Registrant as specified in its charter)
Bermuda (State or other jurisdiction of incorporation or organization) | 98-0429991 (I.R.S. Employer Identification No.) | |
30 Woodbourne Avenue
Hamilton HM 08 Bermuda
(441) 279-5700
(Address, including zip code, and telephone number,
including area code, of Registrant's principal executive office)
None
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class | Name of each exchange on which registered | |
Common Shares, $0.01 per share | New York Stock Exchange, Inc. | |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ý
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ý | Accelerated filer o | Non-accelerated filer o (Do not check if a smaller reporting company) | Smaller reporting company o | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No ý
The aggregate market value of Common Shares held by non-affiliates of the Registrant as of the close of business on June 30, 2014 was $4,209,699,122 (based upon the closing price of the Registrant's shares on the New York Stock Exchange on that date, which was $24.50). For purposes of this information, the outstanding Common Shares which were owned by all directors and executive officers of the Registrant were deemed to be the only shares of Common Stock held by affiliates.
As of February 23, 2015, 155,444,695 Common Shares, par value $0.01 per share, were outstanding (including 43,577 unvested restricted shares).
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of Registrant's definitive proxy statement relating to its 2015 Annual General Meeting of Shareholders are incorporated by reference to Part III of this report.
Forward Looking Statements
This Form 10-K contains information that includes or is based upon forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward looking statements give the expectations or forecasts of future events of Assured Guaranty Ltd. (“AGL”) and its subsidiaries (collectively, “Assured Guaranty” or the “Company”). These statements can be identified by the fact that they do not relate strictly to historical or current facts and relate to future operating or financial performance.
Any or all of Assured Guaranty’s forward looking statements herein are based on current expectations and the current economic environment and may turn out to be incorrect. Assured Guaranty’s actual results may vary materially. Among factors that could cause actual results to differ adversely are:
• | rating agency action, including a ratings downgrade, a change in outlook, the placement of ratings on watch for downgrade, or a change in rating criteria, at any time, of AGL or any of its subsidiaries, and/or of any securities AGL or any of its subsidiaries have issued, and/or of transactions that AGL’s subsidiaries have insured; |
• | reduction in the amount of available insurance opportunities and/or in the demand for Assured Guaranty's insurance; |
• | developments in the world’s financial and capital markets that adversely affect obligors’ payment rates, Assured Guaranty’s loss experience, or its exposure to refinancing risk in transactions (which could result in substantial liquidity claims on its guarantees); |
• | the possibility that budget shortfalls or other factors will result in credit losses or impairments on obligations of state and local governments that Assured Guaranty insures or reinsures; |
• | the failure of Assured Guaranty to realize loss recoveries that are assumed in its expected loss estimates; |
• | deterioration in the financial condition of Assured Guaranty’s reinsurers, the amount and timing of reinsurance recoverables actually received and the risk that reinsurers may dispute amounts owed to Assured Guaranty under its reinsurance agreements; |
• | increased competition, including from new entrants into the financial guaranty industry; |
• | rating agency action on obligors, including sovereign debtors, resulting in a reduction in the value of securities in Assured Guaranty's investment portfolio and in collateral posted by and to Assured Guaranty; |
• | the inability of Assured Guaranty to access external sources of capital on acceptable terms; |
• | changes in the world’s credit markets, segments thereof, interest rates or general economic conditions; |
• | the impact of market volatility on the mark-to-market of Assured Guaranty’s contracts written in credit default swap form; |
• | changes in applicable accounting policies or practices; |
• | changes in applicable laws or regulations, including insurance and tax laws, or other governmental actions; |
• | difficulties with the execution of Assured Guaranty’s business strategy; |
• | loss of key personnel; |
• | the effects of mergers, acquisitions and divestitures; |
• | natural or man-made catastrophes; |
• | other risks and uncertainties that have not been identified at this time; |
• | management’s response to these factors; and |
• | other risk factors identified in AGL’s filings with the U.S. Securities and Exchange Commission (the “SEC”). |
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 in this Form 10-K. The Company undertakes no obligation to update publicly or review any forward looking statement, whether as a result of new information, future developments or otherwise, except as required by law. Investors are advised, however, to consult any further disclosures the Company makes on related subjects in the Company’s reports filed with the SEC.
If one or more of these or other risks or uncertainties materialize, or if the Company’s underlying assumptions prove to be incorrect, actual results may vary materially from what the Company projected. Any forward looking statements in this Form 10-K reflect the Company’s current views with respect to future events and are subject to these and other risks, uncertainties and assumptions relating to its operations, results of operations, growth strategy and liquidity.
For these statements, the Company claims the protection of the safe harbor for forward looking statements contained in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
Convention
Unless otherwise noted, ratings on Assured Guaranty's insured portfolio and on bonds or notes purchased pursuant to loss mitigation strategies ("loss mitigation securities") or risk management strategies are Assured Guaranty’s internal ratings. Internal credit ratings are expressed on a rating scale similar to that used by the rating agencies and generally reflect an approach similar to that employed by the rating agencies, except that Assured Guaranty's internal credit ratings focus on future performance, rather than lifetime performance.
In addition, unless otherwise noted, the Company excludes amounts attributable to loss mitigation securities from par and debt service outstanding, because it manages such securities as investments and not insurance exposure.
ASSURED GUARANTY LTD.
FORM 10-K
TABLE OF CONTENTS
Page | ||
PART I
ITEM 1. | BUSINESS |
Overview
Assured Guaranty Ltd. (“AGL” and, together with its subsidiaries, “Assured Guaranty” or the “Company”) is a Bermuda-based holding company incorporated in 2003 that provides, through its operating subsidiaries, credit protection products to the United States (“U.S.”) and international public finance (including infrastructure) and structured finance markets. The Company applies its credit underwriting judgment, risk management skills and capital markets experience to offer financial guaranty insurance that protects holders of debt instruments and other monetary obligations from defaults in scheduled payments. If an obligor defaults on a scheduled payment due on an obligation, including a scheduled principal or interest payment (“Debt Service”), the Company is required under its unconditional and irrevocable financial guaranty to pay the amount of the shortfall to the holder of the obligation. The Company markets its financial guaranty insurance directly to issuers and underwriters of public finance and structured finance securities as well as to investors in such obligations. The Company guarantees obligations issued principally in the U.S. and the United Kingdom ("U.K"), and also guarantees obligations issued in other countries and regions, including Australia and Western Europe.
The Company conducts its financial guaranty business on a direct basis from the following companies: Assured Guaranty Municipal Corp. ("AGM"), Municipal Assurance Corp. ("MAC"), Assured Guaranty Corp. ("AGC"), and Assured Guaranty (Europe) Ltd. ("AGE"). It also conducts business through Assured Guaranty Re Ltd. ("AG Re"), a Bermuda-based reinsurer. The following is a description of AGL's principal operating subsidiaries:
Assured Guaranty Municipal Corp. AGM is located and domiciled in New York, was organized in 1984 and commenced operations in 1985. Since mid-2008, AGM has provided financial guaranty insurance on debt obligations issued in the U.S. public finance and global infrastructure markets, including bonds issued by U.S. state or governmental authorities or notes issued to finance infrastructure projects. Previously, AGM also offered insurance and reinsurance in the global structured finance market, including asset-backed securities issued by special purpose entities. AGM formerly was named Financial Security Assurance Inc. Assured Guaranty acquired AGM, together with its holding company Financial Security Assurance Holdings Ltd. (renamed Assured Guaranty Municipal Holdings Inc., "AGMH") and the subsidiaries owned by that holding company, on July 1, 2009.
Municipal Assurance Corp. MAC is located and domiciled in New York and was organized in 2008. Assured Guaranty acquired MAC on May 31, 2012. On July 16, 2013, Assured Guaranty completed a series of transactions that increased the capitalization of MAC and resulted in MAC assuming a portfolio of geographically diversified U.S. public finance exposure from AGM and AGC. MAC offers insurance and reinsurance on bonds issued by U.S. state or municipal governmental authorities, focusing on investment grade obligations in select sectors of the municipal market.
Assured Guaranty Corp. AGC is located in New York and domiciled in Maryland, was organized in 1985 and commenced operations in 1988. It provides insurance and reinsurance on debt obligations in the global structured finance market and also offers guarantees on obligations in the U.S. public finance and international infrastructure markets.
Assured Guaranty (Europe) Ltd. AGE is a U.K. incorporated company licensed as a U.K. insurance company and authorized to operate in various countries throughout the European Economic Area ("EEA"). It was organized in 1990 and issued its first financial guarantee in 1994. AGE offers financial guarantees in both the international public finance and structured finance markets and is the primary entity from which the Company writes business in the EEA. As discussed further under "Business" below, AGE has agreed with its regulator that new business it writes would be guaranteed using a co-insurance structure pursuant to which AGE would co-insure municipal and infrastructure transactions with AGM, and structured finance transactions with AGC. AGE must obtain the approval of the Prudential Regulation Authority ("PRA") before it can guarantee any new structured finance transaction.
Assured Guaranty Re Ltd. AG Re is incorporated under the laws of Bermuda and is licensed as a Class 3B insurer under the Insurance Act 1978 and related regulations of Bermuda. AG Re owns, indirectly, Assured Guaranty Re Overseas Ltd. ("AGRO"), which is a Bermuda Class 3A and Class C insurer. AG Re and AGRO underwrite financial guaranty reinsurance. They write business as reinsurers of third-party primary insurers and of certain affiliated companies.
Assured Guaranty is the market leader in the financial guaranty industry. The Company's position in the market has benefited from its acquisition of AGMH in 2009, its ability to maintain strong financial strength ratings, its strong claims-paying resources, its proven willingness to make claim payments to policyholders after obligors have defaulted, and its ability
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to achieve recoveries in respect of the claims that it has paid on insured residential mortgage-backed securities and to resolve troubled municipal credits to which it had exposure.
On December 22, 2014, AGC entered into an agreement to purchase all of the issued and outstanding capital stock of Radian Asset Assurance Inc. ("Radian Asset"), a New York domiciled financial guaranty insurer that ceased writing new business in 2008, for $810 million in cash (subject to adjustment for dividends paid and expenses incurred prior to closing). The Company believes that consummation of the acquisition and the subsequent merger of Radian Asset with and into AGC, which are expected to be completed in the first half of 2015, will enhance the financial condition of AGC and the Company. As of December 31, 2014, Radian Asset had an insured portfolio of $10 billion of statutory public finance net par outstanding and $8 billion of statutory structured finance net par outstanding. Since January 1, 2015, Radian Asset’s statutory structured finance net par outstanding has declined by $3.8 billion as a result of the termination of seven corporate collateralized debt obligation transactions. As of December 31, 2014, Radian Asset had approximately $1,138.9 million of statutory policyholders’ surplus and $189.1 million of contingency reserve.
Since 2009, the Company has continued to face challenges in maintaining its market penetration. The challenges in 2014 were primarily due to:
• | Sustained low interest rate environment in the U.S. Within the last five years, interest rates in the U.S. have been at low levels by historical standards. In fact, benchmark AAA yields, as reflected by the 30 year Municipal Market Date index published by Thomson Reuters, a widely followed industry index, were 133 basis points lower at the end of 2014 than at the beginning of such year. As a result, the difference in yield (or the credit spread) between a bond insured by Assured Guaranty and an uninsured bond has provided comparatively little room for issuer savings and insurance premium, and Assured Guaranty has seen a lower demand for its financial guaranty insurance from issuers than it had prior to 2009. |
• | Continued low volume of issuance in the U.S. public finance market. According to industry compilations, U.S. municipalities issued only $314.9 billion of bonds in 2014, up only 1% from 2013 (which had been 15% less than in 2012). With the exception of 2011, the 2013 volume of issuance in the U.S. public finance market was the lowest since 2001 and 2014 was similar by comparison. In 2015, the Company expects the volume of issuance to continue to be low, in light of austerity measures municipalities have been implementing in order to address budget shortfalls, including those resulting from increased pension and healthcare costs. |
• | Increased competition. The Company estimates, based on third party industry compilations, that of the insured U.S. public finance bonds issued in the primary market in 2014, the Company insured approximately 57.9% of the par, while Build America Mutual Assurance Company ("BAM"), insured 40.3% of the par. National Public Finance Guarantee Corporation, an affiliate of MBIA Insurance Corporation ("MBIA"), insured the remaining 1.8% of the balance. The continued presence in the market of BAM, as well as new entrants, affects the Company's insured volume as well as the amount of premium the Company is able to charge. |
• | Continued uncertainty over the Company's financial strength ratings. When Assured Guaranty issues a financial guaranty on a debt obligation, the rating agencies generally raise the debt or short-term credit ratings of the obligation to the same rating as the financial strength rating of the Assured Guaranty subsidiary that has guaranteed that obligation. Accordingly, investors in products insured by AGM, MAC, AGE or AGC frequently rely on rating agency ratings, and a failure of the insurer to maintain strong financial strength ratings or uncertainty over such ratings would have a negative impact on the demand for its insurance product. The Company's financial strength ratings have been subject to substantial uncertainty in the years subsequent to the financial crisis due to changes in rating agency methodologies for rating financial guaranty insurance companies, periodic rating agency reviews for possible downgrade and actual downgrades. The uncertainty over the Company's financial strength ratings over time has had a negative effect on the demand for the Company's financial guaranties. If the financial strength rating of one or more of the Company's insurance subsidiaries were reduced below current levels, the Company expects that would reduce the number of transactions that would benefit from the Company's insurance and consequently harm the Company's new business opportunities. |
In addition, the Company's business continues to be affected by negative perceptions of the value of the financial guaranty insurance sold by other companies that had been active in the industry. The losses suffered by such other insurers resulted in those companies being downgraded to below-investment-grade ("BIG") levels by the rating agencies and/or subject to intervention by their state insurance regulators. In a number of cases, the state insurance regulators prevented the distressed financial guaranty insurers from paying claims or paying such claims in full; in addition, such financial guaranty insurers were
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perceived by market participants not to be actively conducting surveillance on transactions or fully exercising rights and remedies to mitigate losses.
The Company believes that issuers and investors in securities will continue to purchase financial guaranty insurance, especially if interest rates rise and credit spreads widen. U.S. municipalities have budgetary requirements that are best met through financings in the fixed income capital markets. In particular, smaller municipal issuers frequently use financial guaranties in order to access the capital markets with new debt offerings at a lower all-in interest rate than on an unguaranteed basis. In addition, the Company expects long-term debt financings for infrastructure projects will grow throughout the world, as will the financing needs associated with privatization initiatives or refinancing of infrastructure projects in developed countries.
Financial Guaranty Portfolio
The Company primarily conducts its business through subsidiaries located in the U.S., Europe and Bermuda. The Company generally insures obligations issued in the U.S., although it has also guaranteed securities issued in Europe, Australia and other international markets.
Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a debt instrument or other monetary obligation against non-payment of scheduled principal and interest payments when due. Upon an obligor's default on scheduled principal or interest payments due on the debt obligation, whether due to its insolvency or otherwise, the Company is generally required under the financial guaranty contract to pay the investor the principal or interest shortfall then due.
Financial guaranty insurance may be issued to all of the investors of the guaranteed series or tranche of a municipal bond or structured finance security at the time of issuance of those obligations or it may be issued in the secondary market to only specific individual holders of such obligations who purchase the Company's credit protection.
Both issuers of and investors in financial instruments may benefit from financial guaranty insurance. Issuers benefit when they purchase financial guaranty insurance for their new issue debt transaction because the insurance may have the effect of lowering an issuer's interest cost over the life of the debt transaction to the extent that the insurance premium charged by the Company is less than the net present value of the difference between the yield on the obligation insured by Assured Guaranty (which carries the credit rating of the specific subsidiary that guarantees the debt obligation) and the yield on the debt obligation if sold on the basis of its uninsured credit rating. The principal benefit to investors is that the Company's guaranty provides certainty that scheduled payments will be received when due. The guaranty may also improve the marketability of obligations issued by infrequent or unknown issuers, as well as obligations with complex structures or backed by asset classes new to the market. This benefit to market liquidity, which we call a "liquidity benefit," results from the increase in secondary market trading values for Assured Guaranty-insured obligations as compared with uninsured obligations by the same issuer. In general, the liquidity benefit of financial guaranties is that investors are able to sell insured bonds more quickly and, depending on the financial strength rating of the insurer, at a higher secondary market price than for uninsured debt obligations.
As an alternative to traditional financial guaranty insurance, the Company also provided credit protection relating to a particular security or obligor through a credit derivative contract, such as a credit default swap ("CDS"). Under the terms of a CDS, the seller of credit protection agreed to make a specified payment to the buyer of credit protection if one or more specified credit events occurs with respect to a reference obligation or entity. In general, the credit events specified in the Company's CDS are for interest and principal defaults on the reference obligation. One difference between CDS and traditional primary financial guaranty insurance is that credit default protection was typically provided to a particular buyer of credit protection, who is not always required to own the reference obligation, rather than to all investors in the reference obligation. As a result, the Company's rights and remedies under a CDS may be different and more limited than on a financial guaranty of an entire issuance. Credit derivatives were preferred by some investors, however, because they generally offer the investor ease of execution and standardized terms as well as more favorable accounting or capital treatment. Due to changes in the regulatory environment, the Company has not provided credit protection through a CDS since March 2009, other than in connection with loss mitigation and other remediation efforts relating to its existing book of business. See the Risk Factor captioned "Changes in or inability to comply with applicable law could adversely affect the Company's ability to do business" under Risks Related to GAAP and Applicable Law in "Item 1A. Risk Factors" for additional detail about the regulatory environment.
The Company also offers credit protection through reinsurance, and in the past has provided reinsurance to other financial guaranty insurers with respect to their guaranty of public finance, infrastructure and structured finance obligations. The Company believes that the opportunities currently available to it in the reinsurance market consist primarily of potentially assuming portfolios of transactions from inactive primary insurers and recapturing portfolios that it has previously ceded to third party reinsurers.
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The Company's financial guaranty direct and assumed businesses provide credit protection on public finance, infrastructure and structured finance obligations. For information on the geographic breakdown of the Company's financial guaranty portfolio and on its income and revenue by jurisdiction, see "Geographic Distribution of Net Par Outstanding" in Note 3, Outstanding Exposure, and "Provision for Income Taxes" in Note 13, Income Taxes, of the Financial Statements and Supplementary Data.
U.S. Public Finance Obligations The Company insures and reinsures a number of different types of U.S. public finance obligations, including the following:
General Obligation Bonds are full faith and credit bonds that are issued by states, their political subdivisions and other municipal issuers, and are supported by the general obligation of the issuer to pay from available funds and by a pledge of the issuer to levy ad valorem taxes in an amount sufficient to provide for the full payment of the bonds.
Tax-Backed Bonds are obligations that are supported by the issuer from specific and discrete sources of taxation. They include tax-backed revenue bonds, general fund obligations and lease revenue bonds. Tax-backed obligations may be secured by a lien on specific pledged tax revenues, such as a gasoline or excise tax, or incrementally from growth in property tax revenue associated with growth in property values. These obligations also include obligations secured by special assessments levied against property owners and often benefit from issuer covenants to enforce collections of such assessments and to foreclose on delinquent properties. Lease revenue bonds typically are general fund obligations of a municipality or other governmental authority that are subject to annual appropriation or abatement; projects financed and subject to such lease payments ordinarily include real estate or equipment serving an essential public purpose. Bonds in this category also include moral obligations of municipalities or governmental authorities.
Municipal Utility Bonds are obligations of all forms of municipal utilities, including electric, water and sewer utilities and resource recovery revenue bonds. These utilities may be organized in various forms, including municipal enterprise systems, authorities or joint action agencies.
Transportation Bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, tunnels, municipal parking facilities, toll roads and toll bridges.
Healthcare Bonds are obligations of healthcare facilities, including community based hospitals and systems, as well as of health maintenance organizations and long-term care facilities.
Higher Education Bonds are obligations secured by revenue collected by either public or private secondary schools, colleges and universities. Such revenue can encompass all of an institution's revenue, including tuition and fees, or in other cases, can be specifically restricted to certain auxiliary sources of revenue.
Housing Revenue Bonds are obligations relating to both single and multi-family housing, issued by states and localities, supported by cash flow and, in some cases, insurance from entities such as the Federal Housing Administration.
Infrastructure Bonds include obligations issued by a variety of entities engaged in the financing of infrastructure projects, such as roads, airports, ports, social infrastructure and other physical assets delivering essential services supported by long-term concession arrangements with a public sector entity.
Investor-Owned Utility Bonds are obligations primarily backed by investor-owned utilities, first mortgage bond obligations of for-profit electric or water utilities providing retail, industrial and commercial service, and also include sale-leaseback obligation bonds supported by such entities.
Other Public Finance Bonds include other debt issued, guaranteed or otherwise supported by U.S. national or local governmental authorities, as well as student loans, revenue bonds, and obligations of some not-for-profit organizations.
A portion of the Company's exposure to tax-backed bonds, municipal utility bonds and transportation bonds constitute "special revenue" bonds under the U.S. Bankruptcy Code. Even if an obligor under a special revenue bond were to seek protection from creditors under Chapter 9 of the U.S. Bankruptcy Code, holders of the special revenue bond should continue to receive timely payments of principal and interest during the bankruptcy proceeding, subject to the special revenues being sufficient to pay debt service and the lien on the special revenues being subordinate to the necessary operating expenses of the
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project or system from which the revenues are derived. While "special revenues" acquired by the obligor after bankruptcy remain subject to the pre-petition pledge, special revenue bonds may be adjusted if their claim is determined to be "undersecured."
Non-U.S. Public Finance Obligations The Company insures and reinsures a number of different types of non-U.S. public finance obligations, which consist of both infrastructure projects and other projects essential for municipal function such as regulated utilities. Credit support for the exposures written by the Company may come from a variety of sources, including some combination of subordinated tranches, excess spread, over-collateralization or cash reserves. Additional support also may be provided by transaction provisions intended to benefit noteholders or credit enhancers. The types of non-U.S. public finance securities the Company insures and reinsures include the following:
Infrastructure Finance Obligations are obligations issued by a variety of entities engaged in the financing of international infrastructure projects, such as roads, airports, ports, social infrastructure, and other physical assets delivering essential services supported either by long-term concession arrangements with a public sector entity or a regulatory regime. The majority of the Company's international infrastructure business is conducted in the U.K.
Regulated Utilities Obligations are issued by government-regulated providers of essential services and commodities, including electric, water and gas utilities. The majority of the Company's international regulated utility business is conducted in the U.K.
Pooled Infrastructure Obligations are synthetic asset-backed obligations that take the form of CDS obligations or credit-linked notes that reference either infrastructure finance obligations or a pool of such obligations, with a defined deductible to cover credit risks associated with the referenced obligations.
Other Public Finance Obligations include obligations of local, municipal, regional or national governmental authorities or agencies.
U.S. and Non-U.S. Structured Finance Obligations The Company insures and reinsures a number of different types of U.S. and non-U.S. structured finance obligations. Credit support for the exposures written by the Company may come from a variety of sources, including some combination of subordinated tranches, excess spread, over-collateralization or cash reserves. Additional support also may be provided by transaction provisions intended to benefit noteholders or credit enhancers. The types of U.S. and Non-U.S. Structured Finance obligations the Company insures and reinsures include the following:
Pooled Corporate Obligations are securities primarily backed by various types of corporate debt obligations, such as secured or unsecured bonds, bank loans or loan participations and trust preferred securities ("TruPS"). These securities are often issued in "tranches," with subordinated tranches providing credit support to the more senior tranches. The Company's financial guaranty exposures generally are to the more senior tranches of these issues.
Residential Mortgage-Backed Securities ("RMBS") are obligations backed by closed-end and open-end first and second lien mortgage loans on one-to-four family residential properties, including condominiums and cooperative apartments. First lien mortgage loan products in these transactions include fixed rate, adjustable rate and option adjustable-rate mortgages. The credit quality of borrowers covers a broad range, including "prime", "subprime" and "Alt-A". A prime borrower is generally defined as one with strong risk characteristics as measured by factors such as payment history, credit score, and debt-to-income ratio. A subprime borrower is a borrower with higher risk characteristics, usually as determined by credit score and/or credit history. An Alt-A borrower is generally defined as a prime quality borrower that lacks certain ancillary characteristics, such as fully documented income. The Company has not insured a RMBS transaction since January 2008.
Financial Products is the way in which the Company refers to the guaranteed investment contracts ("GICs") portion of a line of business previously conducted by AGMH that the Company did not acquire when it purchased AGMH in 2009 from Dexia SA. That line of business, which the Company refers to as the former "Financial Products Business" of AGMH, was comprised of its guaranteed investment contracts business, its medium term notes business and the equity payment agreements associated with AGMH's leveraged lease business. When AGMH was still conducting Financial Products Business, AGM issued financial guaranty insurance policies on GICs and in respect of the GIC business; those policies cannot be revoked or canceled. Assured Guaranty is indemnified by Dexia SA and certain of its affiliates ("Dexia") against loss from the former Financial Products Business. The Financial Products Business is currently being run off by Dexia.
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Consumer Receivables Securities are obligations backed by non-mortgage consumer receivables, such as student loans, automobile loans and leases, manufactured home loans and other consumer receivables.
Commercial Mortgage-Backed Securities ("CMBS") are obligations backed by pools of commercial mortgages on office, multi-family, retail, hotel, industrial and other specialized or mixed-use properties.
Commercial Receivables Securities are obligations backed by equipment loans or leases, aircraft and aircraft engine financings, business loans and trade receivables. Credit support is derived from the cash flows generated by the underlying obligations, as well as property or equipment values as applicable.
Insurance Securitization Obligations are obligations secured by the future earnings from pools of various types of insurance/reinsurance policies and income produced by invested assets.
Other Structured Finance Obligations are obligations backed by assets not generally described in any of the other described categories. One such type of asset is a tax benefit to be realized by an investor in one of the Federal or state programs that permit such investor to receive a credit against taxes (such as Federal corporate income tax or state insurance premium tax) for making qualified investments in specified enterprises, typically located in designated low-income areas.
Credit Policy and Underwriting Procedure
Credit Policy
The Company establishes exposure limits and underwriting criteria for obligors, sectors and countries, and in the case of structured finance and infrastructure exposures, for individual transactions. Risk exposure limits for single obligors are based on the Company's assessment of potential frequency and severity of loss as well as other factors, such as historical and stressed collateral performance. Sector limits are based on the Company’s view of stress losses for the sector and on its assessment of intra-sector correlation. Country limits are based on the size and stability of the relevant economy, and the Company’s view of the political environment and legal system. All of the foregoing limits are established in relation to the Company's capital base.
For U.S. public finance transactions, the Company focuses principally on the credit quality of the obligor based on population size and trends, wealth factors, and strength of the economy. The Company evaluates the obligor’s liquidity position; its fiscal management policies and track record; its ability to raise revenues and control expenses; and its exposure to derivative contracts and to debt subject to acceleration. The Company assesses the obligor’s pension and other post-employment benefits obligations and funding policies and evaluates the obligor’s ability to adequately fund such obligations in the future. The Company analyzes other critical risk factors including the type of issue; the repayment source; pledged security, if any; the presence of restrictive covenants and the tenor of the risk. The Company also considers the ability of obligors to file for bankruptcy or receivership under applicable statutes (and on related statutes that provide for state oversight or fiscal control over financially troubled obligors). In addition, the Company weighs the risk of a rating agency downgrade of an obligation's underlying uninsured rating.
For certain transactions, underwriting considerations may also include: the importance of the proposed project to the community; the financial management of a specific project; the potential refinancing risk; and legal or administrative risks.
In cases of not-for-profit institutions, such as healthcare issuers and private higher education issuers, the Company emphasizes the financial stability of the institution, its competitive position and its management experience.
For U.S. infrastructure transactions, the Company's due diligence is generally the same as it is for international infrastructure transactions, as described below.
U.S. structured finance obligations generally present three distinct forms of risk: asset risk, pertaining to the amount and quality of assets underlying an issue; structural risk, pertaining to the extent to which an issue's legal structure provides protection from loss; and execution risk, which is the risk that poor performance by a servicer or collateral manager contributes to a decline in the cash flow available to the transaction. Each of these risks is addressed through the Company's underwriting process.
Generally, the amount and quality of asset coverage required with respect to a structured finance exposure is dependent upon both the historic performance of the asset class, as well as the Company’s view of the future performance of the subject assets. Future performance expectations are developed from historical loss experience, taking into account
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economic, social and political factors affecting that asset class as well as, to the extent feasible, the subject assets themselves. Conclusions are then drawn about the amount of over-collateralization or other credit enhancement necessary in a particular transaction in order to protect investors (and therefore the insurer or reinsurer) against poor asset performance. In addition, structured securities usually are designed to protect investors (and therefore the insurer or reinsurer) from the bankruptcy or insolvency of the entity that originated the underlying assets, as well as the bankruptcy or insolvency of the servicer or manager of those assets.
The Company conducts extensive due diligence on the collateral that support its insured transactions. The principal focus of the due diligence is to confirm the underlying collateral was originated in accordance with the stated underwriting criteria of the asset originator. To this end, such collateral is reviewed, either internally by the Company or by outside consultants that the Company engages. The Company also conducts audits of servicing or other management procedures, reviewing critical aspects of these procedures such as including cash management and collections. The Company may, for certain transactions, obtain background checks on key managers of the originator, servicer or manager of the obligations underlying that transaction.
In general, non-U.S. transactions are comprised of structured finance transactions, transactions with regulated utilities, or infrastructure transactions. For these transactions, the Company undertakes an analysis of the country or countries in which the risk resides, which includes political risk as well as economic and demographic characteristics. For each transaction, the Company also performs an assessment of the legal framework governing the transaction and the laws affecting the underlying assets supporting the obligations to be insured.
The underwriting of structured finance and regulated utilities is generally the same as for U.S. transactions, but for considerations related to the specific country as described in the previous paragraph. For infrastructure transactions, the Company reviews the type of project (e.g., hospital, road, social housing, transportation or student accommodation) and the source of repayment of the debt. For certain transactions, debt service and operational expenses are covered by availability payments made by either a governmental entity or a not-for-profit entity. The availability payments would be due if the project were available for use, regardless of whether the project actually is in use. The principal risks for such transactions are construction risk and operational risk. The project must be completed on time and must be available for use during the life of the concession. For other transactions, notably transactions secured by toll-roads, revenues derived from the project must be sufficient to make debt service payments as well as cover operating expenses during the concession period. The Company undertakes due diligence to assess demand risks in such projects and often uses consultants to help assess future demand and revenue and expense projections.
The Company’s due diligence for infrastructure projects also includes: a financial review of the entity seeking the development of the project (usually a governmental entity or university); a financial and operational review of the developer, the construction companies, and the project operator; and a financial review of the various providers of operational financial protection for the bondholders (and therefore the insurer), including construction surety providers, letter-of-credit providers, liquidity banks or account banks. The Company uses outside consultants to review the construction program and to assess whether the project can be completed on time and on budget. The Company projects the cost of replacing the construction company, including delays in construction, in the event that a construction company is unable to complete the construction for any reason. Construction security packages are sized appropriately to cover these risks and the Company requires such coverage from credit-worthy institutions.
Underwriting Procedure
Each transaction underwritten by the Company involves persons with different expertise across various departments within the Company. The Company's transaction underwriting teams include both underwriting and legal personnel, who analyze the structure of a potential transaction and the credit and legal issues pertinent to the particular line of business or asset class, and accounting and finance personnel, who review the more complex transactions for compliance with applicable accounting standards and investment guidelines.
In the public finance portion of the Company's financial guaranty direct business, underwriters generally analyze the issuer's historical financial statements and, where warranted, develop stress case projections to test the issuers' ability to make timely debt service payments under stressful economic conditions. In the structured and infrastructure finance portions of the Company's financial guaranty direct business, underwriters generally use computer-based financial models in order to evaluate the ability of the transaction to generate adequate cash flow to service the debt under a variety of scenarios. The models include economically stressed scenarios that the underwriters use for their assessment of the potential credit risk inherent in a particular transaction. Stress models developed internally by the Company's underwriters and reflect both empirical research as well as information gathered from third parties, such as rating agencies or investment banks. The Company may also engage advisors
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such as consultants and external counsel to assist in analyzing a transaction's financial or legal risks. The Company may also conduct a due diligence review that includes, among other things, a site visit to the project or facility, meetings with issuer management, review of underwriting and operational procedures, file reviews, and review of financial procedures and computer systems.
Upon completion of the underwriting analysis, the underwriter prepares a formal credit report that is submitted to a credit committee for review. An oral presentation is usually made to the committee, followed by questions from committee members and discussion among the committee members and the underwriters. In some cases, additional information may be presented at the meeting or required to be submitted prior to approval. Each credit committee decision is documented and any further requirements, such as specific terms or evidence of due diligence, are noted. The Company's credit committees are composed of senior officers of the Company. The committees are organized by asset class, such as for public finance or structured finance, or along regulatory lines, to assess the various potential exposures.
Risk Management Procedures
Organizational Structure
The Company's policies and procedures relating to risk assessment and risk management are overseen by its Board of Directors. The Board takes an enterprise-wide approach to risk management that is designed to support the Company's business plans at a reasonable level of risk. A fundamental part of risk assessment and risk management is not only understanding the risks a company faces and what steps management is taking to manage those risks, but also understanding what level of risk is appropriate for the Company. The Board of Directors annually approves the Company's business plan, factoring risk management into account. It also approves the Company's risk appetite statement, which articulates the Company's tolerance for risk and describes the general types of risk that the Company accepts or attempts to avoid. The involvement of the Board in setting the Company's business strategy is a key part of its assessment of management's risk tolerance and also a determination of what constitutes an appropriate level of risk for the Company.
While the Board of Directors has the ultimate oversight responsibility for the risk management process, various committees of the Board also have responsibility for risk assessment and risk management. The Risk Oversight Committee of the Board of Directors oversees the standards, controls, limits, underwriting guidelines and policies that the Company establishes and implements in respect of credit underwriting and risk management. It focuses on management's assessment and management of both (i) credit risks and (ii) other risks, including, but not limited to, financial, legal and operational risks, and risks relating to the Company's reputation and ethical standards. In addition, the Audit Committee of the Board of Directors is responsible for, among other matters, reviewing policies and processes related to the evaluation of risk assessment and risk management, including the Company's major financial risk exposures and the steps management has taken to monitor and control such exposures. It also reviews compliance with legal and regulatory requirements. The Compensation Committee of the Board of Directors reviews compensation-related risks to the Company. The Finance Committee of the Board of Directors oversees the investment of the Company's investment portfolio and the Company's capital structure, liquidity, financing arrangements, rating agency matters, and any corporate development activities in support of the Company's financial plan. The Nominating and Governance Committee of the Board of Directors oversees risk at the Company by developing appropriate corporate governance guidelines and identifying qualified individuals to become board members.
The Company has established a number of management committees to develop underwriting and risk management guidelines, policies and procedures for the Company's insurance and reinsurance subsidiaries that are tailored to their respective businesses, providing multiple levels of credit review and analysis.
• | Portfolio Risk Management Committee—This committee establishes company-wide credit policy for the Company's direct and assumed business. It implements specific underwriting procedures and limits for the Company and allocates underwriting capacity among the Company's subsidiaries. The Portfolio Risk Management Committee focuses on measuring and managing credit, market and liquidity risk for the overall company. All transactions in new asset classes or new jurisdictions must be approved by this committee. |
• | U.S. Management Committee—This committee establishes strategic policy and reviews the implementation of strategic initiatives and general business progress in the U.S. The U.S. Management Committee approves risk policy at the U.S. operating company level. |
• | Risk Management Committees—The U.S., U.K. and AG Re risk management committees conduct an in-depth review of the insured portfolios of the relevant subsidiaries, focusing on varying portions of the portfolio at each |
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meeting. They assign internal ratings of the insured transactions and review sector reports, monthly product line surveillance reports and compliance reports.
• | Workout Committee—This committee receives reports from Surveillance and Workout personnel on transactions that might benefit from active loss mitigation or risk reduction, and approves loss mitigation or risk reduction strategies for such transactions. |
• | Reserve Committees—Oversight of reserving risk is vested in the U.S. Reserve Committee, the AG Re Reserve Committee and the U.K. Reserve Committee. The committees review the reserve methodology and assumptions for each major asset class or significant BIG transaction, as well as the loss projection scenarios used and the probability weights assigned to those scenarios. The reserve committees establish reserves for the relevant subsidiaries, taking into consideration supporting information provided by Surveillance personnel. |
The Company's surveillance personnel are responsible for monitoring and reporting on all transactions in the insured portfolio, including exposures in both the financial guaranty direct and assumed businesses. The primary objective of the surveillance process is to monitor trends and changes in transaction credit quality, detect any deterioration in credit quality, and recommend remedial actions to management. All transactions in the insured portfolio are assigned internal credit ratings, and surveillance personnel recommend adjustments to those ratings to reflect changes in transaction credit quality.
The Company's workout personnel are responsible for managing workout, loss mitigation and risk reduction situations. They work together with the Company's surveillance personnel to develop and implement strategies on transactions that are experiencing loss or could possibly experience loss. They develop strategies designed to enhance the ability of the Company to enforce its contractual rights and remedies and mitigate potential losses. The Company's workout personnel also engage in negotiation discussions with transaction participants and, when necessary, manage (along with legal personnel) the Company's litigation proceedings. They may also make open market or negotiated purchases of securities that the Company has insured, or negotiate or otherwise implement consensual terminations of insurance coverage prior to contractual maturity. The Company's workout personnel work with servicers of residential mortgage-backed securities transactions to enhance their performance.
Direct Business
The Company monitors the performance of each risk in its portfolio and tracks aggregation of risk. The review cycle and scope vary based upon transaction type and credit quality. In general, the review process includes the collection and analysis of information from various sources, including trustee and servicer reports, financial statements, general industry or sector news and analyses, and rating agency reports. For public finance risks, the surveillance process includes monitoring general economic trends, developments with respect to state and municipal finances, and the financial situation of the issuers. For structured finance transactions, the surveillance process can include monitoring transaction performance data and cash flows, compliance with transaction terms and conditions, and evaluation of servicer or collateral manager performance and financial condition. Additionally, the Company uses various quantitative tools and models to assess transaction performance and identify situations where there may have been a change in credit quality. For all transactions, surveillance activities may include discussions with or site visits to issuers, servicers or other parties to a transaction.
Assumed Business
For transactions that the Company has assumed, the ceding insurers are responsible for conducting ongoing surveillance of the exposures that have been ceded to the Company. The Company's surveillance personnel monitor the ceding insurer's surveillance activities on exposures ceded to the Company through a variety of means, including reviews of surveillance reports provided by the ceding insurers, and meetings and discussions with their analysts. The Company's surveillance personnel also monitor general news and information, industry trends and rating agency reports to help focus surveillance activities on sectors or credits of particular concern. For certain exposures, the Company also will undertake an independent analysis and remodeling of the exposure. In the event of credit deterioration of a particular exposure, more frequent reviews of the ceding company's risk mitigation activities are conducted. The Company's surveillance personnel also take steps to ensure that the ceding insurer is managing the risk pursuant to the terms of the applicable reinsurance agreement. To this end, the Company conducts periodic reviews of ceding companies' surveillance activities and capabilities. That process may include the review of the insurer's underwriting, surveillance and claim files for certain transactions.
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Ceded Business
As part of its risk management strategy, the Company has sought in the past to obtain third party reinsurance or retrocessions and may also periodically enter into other arrangements to reduce its exposure to risk concentrations, such as for single risk limits, portfolio credit rating or exposure limits, geographic limits or other factors. At December 31, 2014, the Company had ceded approximately 5% of its principal amount outstanding to third party reinsurers.
The Company has obtained reinsurance to increase its underwriting capacity, both on an aggregate-risk and a single-risk basis, to meet internal, rating agency and regulatory risk limits, diversify risks, reduce the need for additional capital, and strengthen financial ratios. The Company receives capital credit for ceded reinsurance based on the reinsurer's ratings in the capital models used by the rating agencies to evaluate the Company's capital position for its financial strength ratings. In addition, a number of the Company's reinsurers are required to pledge collateral to secure their reinsurance obligations to the Company. In some cases, the pledged collateral augments the rating agency credit for the reinsurance provided. In recent years, most of the Company's reinsurers have been downgraded by one or more rating agency, and consequently, the financial strength ratings of many of the reinsurers are below those of the Company's insurance subsidiaries. While ceding commissions or premium allocation adjustments may compensate in part for such downgrades, the effect of such downgrades, in general, is to decrease the financial benefits of using reinsurance under rating agency capital adequacy models. However, to the extent a reinsurer still has the financial wherewithal to pay, the Company could still benefit from the reinsurance provided.
The Company's ceded reinsurance may be on a quota share, first-loss or excess-of-loss basis. Quota share reinsurance generally provides protection against a fixed percentage of losses incurred by the Company. First-loss reinsurance generally provides protection against losses incurred up to a specified limit. Excess-of-loss reinsurance generally provides protection against a fixed percentage of losses incurred to the extent that losses incurred exceed a specified limit. Reinsurance arrangements typically require the Company to retain a minimum portion of the risks reinsured.
In the past, the Company had both facultative (transaction-by-transaction) and treaty ceded reinsurance contracts with third party reinsurers, generally arranged on an annual basis for new business. The Company also employed "automatic facultative" reinsurance that permitted the Company to apply reinsurance with third party reinsurance to transactions it selected subject to certain limitations. The remainder of the Company's treaty reinsurance provided coverage for a portion, subject in certain cases to adjustment at the Company's election, of the exposure from all qualifying policies issued during the term of the treaty. The reinsurer's participation in a treaty was either cancellable annually upon 90 days' prior notice by either the Company or the reinsurer, or had a one-year term. Treaties generally provide coverage for the full term of the policies reinsured during the annual treaty period, except that, upon a financial deterioration of the reinsurer or the occurrence of certain other events, the Company generally has the right to reassume all or a portion of the business reinsured. Reinsurance agreements may be subject to other termination conditions as required by applicable state law.
The Company's treaty and automatic facultative program covering new business with third party reinsurers ended in 2008, but such reinsurance continues to cover ceded business until the expiration of exposure, except that the Company has entered into commutation agreements reassuming portions of the ceded business from certain reinsurers. The Company continues to reinsure occasionally new business on a facultative basis.
AGC, AGM and MAC entered into an aggregate excess of loss reinsurance facility with a number of reinsurers, effective as of January 1, 2014. The facility covers losses occurring either from January 1, 2014 through December 31, 2021, or January 1, 2015 through December 31, 2022, at the option of AGC, AGM and MAC. It terminates on January 1, 2016, unless AGC, AGM and MAC choose to extend it. The facility covers certain U.S. public finance credits insured or reinsured by AGC, AGM and MAC as of September 30, 2013, excluding credits that were rated non-investment grade as of December 31, 2014 by Moody’s Investor Services, Inc. ("Moody’s") or Standard and Poor's Ratings Services ("S&P") or internally by AGC, AGM or MAC and is subject to certain per credit limits. Among the credits excluded are those associated with the Commonwealth of Puerto Rico and its related authorities and public corporations. The facility attaches when AGC’s, AGM’s and MAC’s net losses (net of AGC’s and AGM's reinsurance (including from affiliates) and net of recoveries) exceed $1.5 billion in the aggregate. The facility covers a portion of the next $500 million of losses, with the reinsurers assuming pro rata in the aggregate $450 million of the $500 million of losses and AGC, AGM and MAC jointly retaining the remaining $50 million of losses. The reinsurers are required to be rated at least AA- or to post collateral sufficient to provide AGM, AGC and MAC with the same reinsurance credit as reinsurers rated AA-. AGM, AGC and MAC are obligated to pay the reinsurers their share of recoveries relating to losses during the coverage period in the covered portfolio. AGC, AGM and MAC have paid approximately $19 million of premiums during 2014 for the term January 1, 2014 through December 31, 2014 and deposited approximately $19 million of securities into trust accounts for the benefit of the reinsurers to be used to pay the premium for January 1, 2015 through December 31, 2015.
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Importance of Financial Strength Ratings
Low financial strength ratings or uncertainty over the Company's ability to maintain its financial strength ratings would have a negative impact on issuers' and investors' perceptions of the value of the Company's insurance product. Therefore, the Company manages its business with the goal of achieving high financial strength ratings, preferably the highest that an agency will assign. However, the models used by rating agencies differ, presenting conflicting goals that may make it inefficient or impractical to reach the highest rating level. In addition, the models are not fully transparent, contain subjective factors and change frequently.
Historically, insurance financial strength ratings reflect an insurer's ability to pay under its insurance policies and contracts in accordance with their terms. The rating is not specific to any particular policy or contract. Historically, insurance financial strength ratings do not refer to an insurer's ability to meet non-insurance obligations and are not a recommendation to purchase any policy or contract issued by an insurer or to buy, hold, or sell any security insured by an insurer. The insurance financial strength ratings assigned by the rating agencies are based upon factors that the rating agencies believe are relevant to policyholders and are not directed toward the protection of investors in AGL's common shares. Ratings reflect only the views of the respective rating agencies and are subject to continuous review and revision or withdrawal at any time.
Following the financial crisis, the rating process has been challenging for the Company due to a number of factors, including:
• | Instability of Rating Criteria and Methodologies. Rating agencies purport to issue ratings pursuant to published rating criteria and methodologies. In recent years, the rating agencies have made material changes to their rating criteria and methodologies applicable to financial guaranty insurers, sometimes through formal changes and other times through ad hoc adjustments to the conclusions reached by existing criteria. Furthermore, these criteria and methodology changes are typically implemented without any transition period, making it difficult for an insurer to comply quickly with new standards. |
• | Instability of Severe Stress Case Loss Assumptions. A major component in arriving at a financial guaranty insurer's rating has been the rating agency’s assessment of the insurer’s capital adequacy, with each rating agency employing its own proprietary model. These capital adequacy approaches include “stress case” loss assumptions for various risks or risk categories. Since the financial crisis, the rating agencies have at various times materially increased stress case loss assumptions for various risks or risk categories, in some cases later reducing such stress case losses. This approach has made predicting the amount of capital required to maintain or attain a certain rating more difficult. |
• | More Reliance on Qualitative Rating Criteria. In prior years, the financial strength ratings of the Company’s insurance company subsidiaries were largely consistent with the rating agency’s assessment of the insurers’ capital adequacy, such that a rating downgrade could generally be avoided by raising additional capital or otherwise improving capital adequacy under the rating agency’s model. In recent years, however, both S&P and Moody’s have applied other factors, some of which are subjective, such as the insurer's business strategy and franchise value or the anticipated future demand for its product, to justify ratings for the Company’s insurance company subsidiaries significantly below the ratings implied by their own capital adequacy models. Currently, for example, S&P has concluded that AGM has “AAA” capital adequacy under the S&P model (but subject to a downward adjustment due to a “large obligor test”) and Moody’s has concluded that AGM has “Aa” capital adequacy under the Moody’s model (offset by other factors including the rating agency’s assessment of competitive profile, future profitability and market share). |
Despite the difficult rating agency process following the financial crisis, the Company has been able to maintain strong financial strength ratings. However, if a substantial downgrade of the financial strength ratings of the Company's insurance subsidiaries were to occur in the future, such downgrade would adversely affect its business and prospects and, consequently, its results of operations and financial condition. The Company believes that if the financial strength ratings of AGM, AGC and/or MAC were downgraded from their current levels, such downgrade could result in downward pressure on the premium that such insurance subsidiary would be able to charge for its insurance. Currently, AGM, AGC and MAC all have AA (Stable Outlook) financial strength ratings from S&P. Each of AGM and MAC also has a AA+ (Stable Outlook) financial strength rating from Kroll Bond Rating Agency ("KBRA"), while AGM and AGC have financial strength ratings in the single-A category from Moody's (A2 (Stable Outlook) and A3 (Negative Outlook), respectively. The Company believes that so long as AGM, AGC and/or MAC continue to have financial strength ratings in the double-A category from at least one of the legacy rating agencies (S&P or Moody’s), they are likely to be able to continue writing financial guaranty business with a credit quality similar to that historically written. However, if both legacy rating agencies were to reduce the financial strength ratings of AGM, AGC and/or MAC to the single-A level or below, or if either legacy rating agency were to downgrade AGM, AGC
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and/or MAC below the single-A level, it could be difficult for the Company to originate the current volume of new business with comparable credit characteristics. See the Risk Factor captioned "Risks Related to the Company's Financial Strength and Financial Enhancement Ratings" in "Item 1A. Risk Factors" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" for more information about the Company's ratings.
Investments
Investment income from the Company's investment portfolio is one of the primary sources of cash flows supporting its operations and claim payments. The Company's total investment portfolio was $11.4 billion and $10.8 billion as of December 31, 2014 and 2013, respectively, and generated net investment income of $403 million, $393 million and $404 million in 2014, 2013 and 2012, respectively.
The Company's principal objectives in managing its investment portfolio are to support the highest possible ratings for each operating company; maintain sufficient liquidity to cover unexpected stress in the insurance portfolio; and maximize total after-tax net investment income. If the Company's calculations with respect to its policy liabilities are incorrect or other unanticipated payment obligations arise, or if the Company improperly structures its investments to meet these liabilities, it could have unexpected losses, including losses resulting from forced liquidation of investments before their maturity. The investment policies of the Company's insurance subsidiaries are subject to insurance law requirements, and may change depending upon regulatory, economic and market conditions and the existing or anticipated financial condition and operating requirements, including the tax position, of the businesses.
Approximately 90.4% of the Company's investment portfolio is externally managed by its investment managers: BlackRock Financial Management, Inc., Deutsche Investment Management Americas Inc., General Re-New England Asset Management, Inc. and Wellington Management Company, LLP. The performance of the Company's invested assets is subject to the ability of the investment managers to select and manage appropriate investments. The Company's investment managers have discretionary authority over the Company's investment portfolio within the limits of the Company's investment guidelines approved by the Company's Board of Directors. The Company's portfolio is allocated approximately equally among the four investment managers and each manager is compensated based upon a fixed percentage of the market value of the portion of the portfolio being managed by such manager. During the years ended December 31, 2014, 2013 and 2012, the Company recorded investment management fee expenses of $9 million, $8 million, and $9 million, respectively, related to these managers.
The Company also internally managed 9.6% of the investment portfolio, either in connection with its loss mitigation or risk management strategy, or because the Company believes a particular security or asset presents an attractive investment opportunity.
The largest component of the Company’s internally managed portfolio consists of obligations that the Company purchases in connection with its loss mitigation or risk management strategy for its insured exposure. Purchasing such obligations enables the Company to exercise rights available to holders of the obligations. The Company also holds other invested assets that were obtained or purchased as part of negotiated settlements with insured counterparties or under the terms of its financial guaranties. The Company held approximately $881 million and $843 million of securities based on their fair value, after elimination of the benefit of any insurance provided by the Company, that were obtained for loss mitigation or risk management purposes in its internally managed investment accounts as of December 31, 2014 and December 31, 2013, respectively.
Competition
Assured Guaranty is the market leader in the financial guaranty industry. Assured Guaranty believes its financial strength, protection against defaults, credit selection policies, underwriting standards and surveillance procedures make it an attractive provider of financial guaranties.
Its principal competition is in the form of obligations that issuers decide to issue on an uninsured basis. In the U.S. public finance market, when interest rates are low, investors may prefer greater yield over insurance protection, and issuers may find the cost savings from insurance less compelling. In 2014, 30-year municipal interest rates fell approximately 133 basis points from their level at year-end 2013, a year in which such rates were already low by historical standards. In 2014, municipal yields were near record lows.
Nevertheless, in the U.S. public finance market in 2014, usage of municipal bond insurance increased to approximately 5.9% of the par amount of new issues sold, compared with approximately 3.9% in 2013. The Company believes the increase in market penetration despite falling interest rates indicates greater demand for bond insurance based on investors’
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heightened awareness of municipal issuers’ potential to come under financial stress (due to such high-profile cases as Detroit’s bankruptcy) and evidence that Assured Guaranty insured bonds held their market value better than comparable uninsured bonds in distressed situations.
In the international infrastructure finance market, the uninsured execution serving as the Company’s principal competition occurs primarily in privately funded transactions where no bonds are sold in the public markets. In the structured finance market, the uninsured execution occurs in both public and primary transactions primarily where bonds are sold with sufficient credit or structural enhancement embedded in transactions, such as through overcollateralization, first loss insurance, excess spread or other terms, to make the bonds attractive to investors without bond insurance.
Assured Guaranty is the only financial guaranty company active before the global financial crisis of 2008 that has maintained sufficient financial strength to write new business continuously since the crisis began. As a result of rating agency downgrades of the financial strength ratings of financial guaranty competitors active before the crisis, Assured Guaranty’s only significant financial guaranty competitor in 2014 was BAM, a mutual insurance company that commenced business in 2012.
Based on industry statistics, the Company estimates that, of the new U.S. public finance bonds sold with insurance in 2014, the Company insured approximately 57.9% of the par, while BAM insured approximately 40.3%. BAM is effective in competing with the Company for small to medium sized U.S. public finance transactions in certain sectors, and its pricing and underwriting strategies may have a negative impact on the amount of premium the Company is able to charge for its insurance. However, the Company believes it has competitive advantages over BAM due to: AGM's and MAC's larger capital base; AGM's ability to insure larger transactions and issuances in more diverse U.S. bond sectors; and AGM's and MAC's strong financial strength ratings from multiple rating agencies (in the case of AGM, AA+ from KBRA, AA from S&P and A2 from Moody's, and in the case of MAC, AA+ from KBRA and AA from S&P, compared with BAM's AA solely from S&P). Additionally, as a public company with access to both the equity and debt capital markets, Assured Guaranty may have greater flexibility to raise capital, if needed.
Another potentially significant competitor to the Company on U.S. public finance transactions is National, which guaranteed three transactions sold in the primary market in 2014. In 2009, MBIA, one of the legacy insurers that is not writing new business, transferred its U.S. public finance exposures to its affiliate National. The transfer was challenged in litigation that was not settled until May 2013. Subsequently, S&P has raised National’s financial strength rating from BBB to AA-, noting that S&P no longer viewed MBIA’s rating as a limitation on National’s rating, and Moody’s has upgraded National's financial strength rating from Baa2 to A3.
In the global structured finance and infrastructure markets, Assured Guaranty is the only financial guaranty insurance company currently writing new guarantees. Management considers the Company’s greater diversification to be a competitive advantage in the long run because it means the Company is not wholly dependent on conditions in any one market.
In the future, additional new entrants into the financial guaranty industry could reduce the Company's new business prospects, including by furthering price competition or offering financial guaranty insurance on transactions with structural and security features that are more favorable to the issuers than those required by Assured Guaranty. However, the Company believes that the presence of multiple guarantors might also increase the overall visibility and acceptance of the product by a broadening group of investors, and the fact that investors are willing to commit fresh capital to the industry may promote market confidence in the product.
In addition to monoline insurance companies, Assured Guaranty competes with other forms of credit enhancement, such as letters of credit or credit derivatives provided by banks and other financial institutions, some of which are governmental enterprises, or direct guaranties of municipal, structured finance or other debt by federal or state governments or government sponsored or affiliated agencies. Alternative credit enhancement structures, and in particular federal government credit enhancement or other programs, can interfere with the Company's new business prospects, particularly if they provide direct governmental-level guaranties, restrict the use of third-party financial guaranties or reduce the amount of transactions that might qualify for financial guaranties.
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Regulation
General
The business of insurance and reinsurance is regulated in most countries, although the degree and type of regulation varies significantly from one jurisdiction to another. Reinsurers are generally subject to less direct regulation than primary insurers. The Company is subject to regulation under applicable statutes in the U.S., the U.K. and Bermuda, as well as applicable statutes in Australia.
United States
AGL has three operating insurance subsidiaries domiciled in the U.S., which the Company refers to collectively as the "Assured Guaranty U.S. Subsidiaries."
• | AGM is a New York domiciled insurance company licensed to write financial guaranty insurance and reinsurance in 50 U.S. states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. |
• | MAC is a New York domiciled insurance company licensed to write financial guaranty insurance and reinsurance in 50 U.S. states and the District of Columbia. MAC will only insure U.S. public finance debt obligations, focusing on investment grade bonds in select sectors of that market. |
• | AGC is a Maryland domiciled insurance company licensed to write financial guaranty insurance and reinsurance (which is classified in some states as surety or another line of insurance) in 50 U.S. states, the District of Columbia and Puerto Rico. AGC is registered as a foreign company in Australia and currently operates through a representative office in Sydney; it currently intends to withdraw its registration in Australia effective March 31, 2015. |
Insurance Holding Company Regulation
AGL and the Assured Guaranty U.S. Subsidiaries are subject to the insurance holding company laws of their jurisdiction of domicile, as well as other jurisdictions where these insurers are licensed to do insurance business. These laws generally require each of the Assured Guaranty U.S. Subsidiaries to register with its respective domestic state insurance department and annually to furnish financial and other information about the operations of companies within their holding company system. Generally, all transactions among companies in the holding company system to which any of the Assured Guaranty U.S. Subsidiaries is a party (including sales, loans, reinsurance agreements and service agreements) must be fair and, if material or of a specified category, such as reinsurance or service agreements, require prior notice and approval or non-disapproval by the insurance department where the applicable subsidiary is domiciled.
Change of Control
Before a person can acquire control of a U.S. domestic insurance company, prior written approval must be obtained from the insurance commissioner of the state where the domestic insurer is domiciled. Generally, state statutes provide that control over a domestic insurer is presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing, 10% or more of the voting securities of the domestic insurer. Prior to granting approval of an application to acquire control of a domestic insurer, the state insurance commissioner will consider such factors as the financial strength of the applicant, the integrity and management of the applicant's board of directors and executive officers, the acquirer's plans for the management of the applicant's board of directors and executive officers, the acquirer's plans for the future operations of the domestic insurer and any anti-competitive results that may arise from the consummation of the acquisition of control. These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control involving AGL that some or all of AGL's stockholders might consider to be desirable, including in particular unsolicited transactions.
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State Insurance Regulation
State insurance authorities have broad regulatory powers with respect to various aspects of the business of U.S. insurance companies, including licensing these companies to transact business, accreditation of reinsurers, admittance of assets to statutory surplus, regulating unfair trade and claims practices, establishing reserve requirements and solvency standards, regulating investments and dividends and, in certain instances, approving policy forms and related materials and approving premium rates. State insurance laws and regulations require the Assured Guaranty U.S. Subsidiaries to file financial statements with insurance departments everywhere they are licensed, authorized or accredited to conduct insurance business, and their operations are subject to examination by those departments at any time. The Assured Guaranty U.S. Subsidiaries prepare statutory financial statements in accordance with Statutory Accounting Practices, or SAP, and procedures prescribed or permitted by these departments. State insurance departments also conduct periodic examinations of the books and records, financial reporting, policy filings and market conduct of insurance companies domiciled in their states, generally once every three to five years. Market conduct examinations by regulators other than the domestic regulator are generally carried out in cooperation with the insurance departments of other states under guidelines promulgated by the National Association of Insurance Commissioners.
The Maryland Insurance Administration (the "MIA"), the regulatory authority of the domiciliary jurisdiction of AGC, conducts a periodic examination of insurance companies domiciled in Maryland every five years. In 2013, the MIA issued an Examination Report with respect to AGC for the five year period ending December 31, 2011; no significant regulatory issues were noted in such report.
The New York State Department of Financial Services (the "NYDFS"), the regulatory authority of the domiciliary jurisdiction of AGM and MAC, also conducts a periodic examination of insurance companies domiciled in New York, also usually at five-year intervals. In 2012, the NYDFS commenced examinations of AGM, MAC, Assured Guaranty Municipal Insurance Company and AG Mortgage in order for its examinations of these companies to coincide with the MIA's examination of AGC. In 2013, the NYDFS completed its examinations and issued Reports on Examination of AGM for the four-year period ending December 31, 2011 and MAC for the period September 26, 2008 through June 30, 2012. The reports also did not note any significant regulatory issues concerning those companies.
State Dividend Limitations
New York. One of the primary sources of cash for the payment of debt service and dividends by the Company is the receipt of dividends from AGM. Under the New York Insurance Law, AGM may only pay dividends out of "earned surplus," which is that portion of the company's surplus that represents the net earnings, gains or profits (after deduction of all losses) that have not been distributed to shareholders as dividends or transferred to stated capital or capital surplus, or applied to other purposes permitted by law, but does not include unrealized appreciation of assets. AGM may pay dividends without the prior approval of the New York Superintendent of Financial Services ("New York Superintendent") that, together with all dividends declared or distributed by it during the preceding 12 months, does not exceed 10% of its policyholders' surplus (as of its last annual or quarterly statement filed with the New York Superintendent) or 100% of its adjusted net investment income during that period. The maximum amount available during 2015 for AGM to pay dividends to its parent AGMH without regulatory approval, after giving effect to dividends paid in the prior 12 months, is estimated to be approximately $227 million, of which approximately $67 million is available for distribution in the first quarter of 2015. AGM paid dividends of $160 million, $163 million and $30 million during 2014, 2013 and 2012, respectively, to AGMH.
Maryland. Another primary source of cash for the payment of debt service and dividends by the Company is the receipt of dividends from AGC. Under Maryland's insurance law, AGC may, with prior notice to the MIA, pay an ordinary dividend that, together with all dividends paid in the prior 12 months, does not exceed 10% of its policyholders' surplus (as of the prior December 31) or 100% of its adjusted net investment income during that period. The maximum amount available during 2015 for AGC to pay ordinary dividends to its parent Assured Guaranty US Holdings Inc. ("AGUS") will be approximately $90 million, of which approximately $21 million is available for distribution in the first quarter of 2015, after giving effect to dividends paid in the prior 12 months. A dividend or distribution to a stockholder in excess of this limitation would constitute an "extraordinary dividend," which must be paid out of "earned surplus" and reported to, and approved by, the MIA prior to payment. "Earned surplus" is that portion of the company's surplus that represents the net earnings, gains or profits (after deduction of all losses) that have not been distributed to shareholders as dividends or transferred to stated capital or capital surplus, or applied to other purposes permitted by law, but does not include unrealized capital gains and appreciation of assets. Currently, AGC does not have any earned surplus and therefore the Company expects AGC only to pay ordinary dividends in 2015. AGC may not pay any dividend or make any distribution, including ordinary dividends, unless it notifies the MIA of the proposed payment within five business days following declaration and at least ten days before payment. The MIA may declare that such dividend not be paid if it finds that AGC's policyholders' surplus would be inadequate after payment of
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the dividend or the dividend could lead AGC to a hazardous financial condition. AGC paid dividends of $69 million, $67 million and $55 million during 2014, 2013 and 2012, respectively, to AGUS.
Contingency Reserves
New York. Under the New York Insurance Law, each of AGM and MAC must establish a contingency reserve to protect policyholders. As financial guaranty insurers, each is required to maintain a contingency reserve:
• | with respect to policies written prior to July 1, 1989, in an amount equal to 50% of earned premiums less permitted reductions; and |
• | with respect to policies written on and after July 1, 1989, quarterly on a pro rata basis over a period of 20 years for municipal bonds and 15 years for all other obligations, in an amount equal to the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.50%, depending on the type of obligation guaranteed, until the contingency reserve amount for the category equals the applicable percentage of net unpaid principal. The contingency reserve is then taken down over the same period of time that it was established. |
Maryland. In accordance with Maryland insurance law and regulations, AGC also maintains a statutory contingency reserve for the protection of policyholders. The contingency reserve is maintained quarterly on a pro rata basis over a period of 20 years for municipal bonds and 15 years for all other obligations, in an amount equal to the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.50%, depending on the type of obligation guaranteed, until the contingency reserve amount for the category equals the applicable percentage of net unpaid principal. The contingency reserve is then taken down over the same period of time that it was established.
In both New York and Maryland, when considering the principal amount guaranteed, the insurer is permitted to take into account amounts that it has ceded to reinsurers. In addition, releases from the insurer's contingency reserve may be permitted under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer's outstanding insured obligations.
From time to time, AGM and AGC have obtained approval from their regulators to release contingency reserves based on losses or because the accumulated reserve is deemed excessive in relation to the insurer's outstanding insured obligations. In 2014, on the latter basis, AGM obtained NYDFS approval for a contingency reserve release of approximately $588 million and AGC obtained MIA approval for a contingency reserve release of approximately $540 million.
In addition to the releases described above, in July 2013, AGM obtained approval from the NYDFS, and AGC obtained approval from the MIA, to reassume in three annual installments all of the outstanding contingency reserves that AGM and its wholly-owned subsidiary, AGE (together, the "AGM Group"), and AGC, respectively, ceded to its affiliate AG Re and to cease ceding further contingency reserves to AG Re. In July 2013, AGM and AGC each completed the first of these three annual installments by reassuming approximately $73 million and $88 million, respectively, of ceded contingency reserves. These first reassumptions together permitted the release of assets from the AG Re trust accounts securing AG Re's reinsurance of AGM and AGC by approximately $130 million, after adjusting for increases in the amounts required to be held in such accounts due to changes in asset values, thereby increasing the Company’s unencumbered assets. In August 2014, AGM and AGC each completed the second of these three annual installments by reassuming approximately $110 million and $134 million, respectively, of ceded contingency reserves. In addition, in the fourth quarter of 2014, AGE completed the first and second annual installments concurrently by reassuming an approximate aggregate of $24.5 million of ceded contingency reserves. These 2014 reassumptions collectively permitted the release of assets from the AG Re trust accounts securing AG Re's reinsurance of the AGM Group and AGC by approximately $274 million, after adjusting for increases in the amounts required to be held in such accounts due to changes in asset values, thereby increasing the Company’s unencumbered assets. The third reassumption installment of approximately $42.5 million by the AGM Group and approximately $45 million by AGC is intended to be completed on the two year anniversary of the first reassumption installment, and is subject to further approval by the NYDFS and MIA.
Financial guaranty insurers are also required to maintain a loss and loss adjustment expense ("LAE") reserve (on a case-by-case basis) and unearned premium reserve.
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Single and Aggregate Risk Limits
The New York Insurance Law and the Code of Maryland Regulations establish single risk limits for financial guaranty insurers applicable to all obligations issued by a single entity and backed by a single revenue source. For example, under the limit applicable to qualifying asset-backed securities, the lesser of:
• | the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, or |
• | the insured unpaid principal (reduced by the extent to which the unpaid principal of the supporting assets exceeds the insured unpaid principal) divided by nine, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves, subject to certain conditions. |
Under the limit applicable to municipal obligations, the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer's policyholders' surplus and contingency reserves. In addition, insured principal of municipal obligations attributable to any single risk, net of qualifying reinsurance and collateral, is limited to 75% of the insurer's policyholders' surplus and contingency reserves. Single-risk limits are also specified for other categories of insured obligations, and generally are more restrictive than those listed for asset-backed or municipal obligations. Obligations not qualifying for an enhanced single-risk limit are generally subject to the "corporate" limit (applicable to insurance of unsecured corporate obligations) equal to 10% of the sum of the insurer's policyholders' surplus and contingency reserves. For example, "triple-X" and "future flow" securitizations, as well as unsecured investor-owned utility obligations, are generally subject to these "corporate" single-risk limits.
The New York Insurance Law and the Code of Maryland Regulations also establish aggregate risk limits on the basis of aggregate net liability insured as compared with statutory capital. "Aggregate net liability" is defined as outstanding principal and interest of guaranteed obligations insured, net of qualifying reinsurance and collateral. Under these limits, policyholders' surplus and contingency reserves must not be less than the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for certain municipal obligations to 4% for certain non-investment-grade obligations. As of December 31, 2014, the aggregate net liability of each of AGM, MAC and AGC utilized approximately 31.5%, 45.0% and 20.5% of their respective policyholders' surplus and contingency reserves.
The New York Superintendent has broad discretion to order a financial guaranty insurer to cease new business originations if the insurer fails to comply with single or aggregate risk limits. In practice, the New York Superintendent has shown a willingness to work with insurers to address these concerns.
Group Regulation
In connection with AGL’s establishment of tax residence in the United Kingdom, as discussed in greater detail under "Tax Matters" below, AGL has been discussing the regulation of AGL and its subsidiaries as a group with the Prudential Regulation Authority in the U.K. and with the NYDFS. The NYDFS has assumed responsibility for regulation of the Assured Guaranty group. Group supervision by the NYDFS results in additional regulatory oversight over Assured Guaranty, and may subject Assured Guaranty to new regulatory requirements and constraints.
Investments
The Assured Guaranty U.S. Subsidiaries are subject to laws and regulations that require diversification of their investment portfolio and limit the amount of investments in certain asset categories, such as BIG fixed-maturity securities, equity real estate, other equity investments, and derivatives. Failure to comply with these laws and regulations would cause investments exceeding regulatory limitations to be treated as non-admitted assets for purposes of measuring surplus, and, in some instances, would require divestiture of such non-qualifying investments. The Company believes that the investments made by the Assured Guaranty U.S. Subsidiaries complied with such regulations as of December 31, 2014. In addition, any investment must be approved by the insurance company's board of directors or a committee thereof that is responsible for supervising or making such investment.
Operations of the Company's Non-U.S. Insurance Subsidiaries
In addition to the regulatory requirements imposed by the jurisdictions in which they are licensed, the business operations of the Company's reinsurance subsidiaries are affected by regulatory requirements in various states of the United States governing "credit for reinsurance", which are imposed on the ceding companies of the reinsurers. The Nonadmitted and Reinsurance Reform Act (“NRRA”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank
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Act”) streamlined the regulation of reinsurance by applying single state regulation for credit for reinsurance. Under the NRRA, credit for reinsurance determinations are controlled by the ceding company’s state of domicile and non-domiciliary states are prohibited from applying their reinsurance laws extraterritorially. In general, a ceding company which obtains reinsurance from a reinsurer that is licensed, accredited or approved by the ceding company's state of domicile is permitted to reflect in its statutory financial statements a credit in an aggregate amount equal to the ceding company's liability for unearned premiums (which are that portion of premiums written which applies to the unexpired portion of the policy period), loss and loss expense reserves ceded to the reinsurer. The great majority of states, however, permit a credit on the statutory financial statements of a ceding insurer for reinsurance obtained from a non-licensed or non-accredited reinsurer to the extent that the reinsurer secures its reinsurance obligations to the ceding insurer by providing a letter of credit, trust fund or other acceptable security arrangement. A few states do not allow credit for reinsurance ceded to non-licensed reinsurers except in certain limited circumstances and others impose additional requirements that make it difficult to become accredited. The Company's reinsurance subsidiaries AG Re and AGRO are not licensed, accredited or approved in any state and have established trusts to secure their reinsurance obligations.
U.S. Federal Regulation
The Company’s businesses are subject to direct and indirect regulation under U.S. federal law. In particular, the Dodd-Frank Act could require certain of AGL's subsidiaries to register with the SEC as major security-based swap participants when those registration rules take effect. Major security-based swap participants would need to satisfy the SEC's regulatory margin and capital requirements and would be subject to additional compliance requirements. In addition, certain of AGL's subsidiaries may need to post margin with respect to either future or legacy derivative transactions when rules relating to margin take effect for derivatives dealers. At this time, AGL does not believe its subsidiaries are required to register with the Commodity Futures Trading Commission ("CFTC") as major swap participants, based on the Company's calculations of the subsidiaries' swap exposure.
Bermuda
AG Re and AGRO are each an insurance company currently registered and licensed under the Insurance Act 1978 of Bermuda, amendments thereto and related regulations (collectively, the "Insurance Act"). AG Re is registered and licensed as a Class 3B insurer and AGRO is registered and licensed as a Class 3A insurer and a Class C long-term insurer.
Bermuda Insurance Regulation
The Insurance Act imposes on insurance companies certain solvency and liquidity standards; certain restrictions on the declaration and payment of dividends and distributions; certain restrictions on the reduction of statutory capital; certain restrictions on the winding up of long-term insurers; and certain auditing and reporting requirements and also the need to have a principal representative and a principal office (as understood under the Insurance Act) in Bermuda. The Insurance Act grants to the Bermuda Monetary Authority (the "Authority") the power to cancel insurance licenses, supervise, investigate and intervene in the affairs of insurance companies and in certain circumstances share information with foreign regulators. Class 3A and Class 3B insurers are authorized to carry on general insurance business (as understood under the Insurance Act), subject to conditions attached to the license and to compliance with minimum capital and surplus requirements, solvency margin, liquidity ratio and other requirements imposed by the Insurance Act. Class C long-term insurers are permitted to carry on long-term business (as understood under the Insurance Act) subject to conditions attached to the license and to similar compliance requirements and the requirement to maintain its long-term business fund (a segregated fund). Each of AG Re and AGRO is required annually to file statutorily mandated financial statements and returns, audited by an auditor approved by the Authority (no approved auditor of an insurer may have an interest in that insurer, other than as an insured, and no officer, servant or agent of an insurer shall be eligible for appointment as an insurer's approved auditor), together with an annual loss reserve opinion of the Authority approved loss reserve specialist and in respect of AGRO, the required actuary's certificate with respect to the long-term business. AG Re is also required to file annual financial statements prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"), which must be available to the public. As Class 3A insurer, AGRO has filed for an exemption from the Authority from making such filing. In addition, AG Re is required to file a capital and solvency return that includes the company's Bermuda Solvency Capital Requirement ("BSCR") model (or an approved internal capital model in lieu thereof), a schedule of fixed income investments by rating categories, a schedule of net reserves for losses and loss expense provisions by line of business, a schedule of premiums written by line of business, a schedule of risk management, a schedule of fixed income securities, a schedule of commercial insurer's solvency self assessment ("CISSA"), a schedule of catastrophe risk return, a schedule of loss triangles or reconciliation of net loss reserves and a schedule of eligible capital. AG Re is also required to file, on a quarterly basis, the relevant materials provided to the AG Re/ AGRO Board of Directors, including unaudited quarterly financial information and details of material intra-group transactions and risk concentrations.
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AGRO is also required to file a capital and solvency return that includes, among other details, the company's Bermuda Solvency Capital Requirement—Small and Medium Entities ("BSCR-SME") model (or an approved internal capital model in lieu thereof), the CISSA and a schedule of eligible capital.
Shareholder Controllers
Pursuant to provisions in the Insurance Act, any person who becomes a holder of 10% or more, 20% or more, 33% or more or 50% or more of the Company's common shares must notify the Authority in writing within 45 days of becoming such a holder. The Authority has the power to object to such a person if it appears to the Authority that the person is not fit and proper to be such a holder. In such a case, the Authority may require the holder to reduce their shareholding in the Company and may direct, among other things, that the voting rights attaching to their common shares shall not be exercisable. A person that does not comply with such a notice or direction from the Authority will be guilty of an offense.
Notification of Material Changes
All registered insurers are required to give notice to the Authority of their intention to effect a material change within the meaning of the Insurance Act. For the purposes of the Insurance Act, the following changes are material: (i) the transfer or acquisition of insurance business being part of a scheme falling under section 25 of the Insurance Act or section 99 of the Companies Act 1981 of Bermuda (the "Companies Act"), (ii) the amalgamation with or acquisition of another firm, (iii) engaging in unrelated business that is retail business, (iv) the acquisition of a controlling interest in an undertaking that is engaged in non-insurance business which offers services or products to non-affiliated persons, (v) outsourcing all or substantially all of the functions of actuarial, risk management, compliance and internal audit, (vi) outsourcing all or a material part of an insurer's underwriting activity, (vii) transferring other than by way of reinsurance all or substantially all of a line of business and (viii) expanding into a material new line of business.
No registered insurer shall take any steps to give effect to a material change unless it has first served notice on the Authority that it intends to effect such material change and, before the end of 14 days, either the Authority has notified such company in writing that it has no objection to such change or that period has lapsed without the Authority having issued a notice of objection. A person who fails to give the required notice or who effects a material change, or allows such material change to be effected, before the prescribed period has elapsed or after having received a notice of objection shall be guilty of an offence.
Minimum Solvency Margin and Enhanced Capital Requirements
Under the Insurance Act, AG Re and AGRO must each ensure that the value of its general business assets exceeds the amount of its general business liabilities by an amount greater than the prescribed minimum solvency margin and each company's applicable enhanced capital requirement.
The minimum solvency margin for Class 3A and Class 3B insurers is the greater of (i) $1 million, or (ii) 20% of the first $6 million of net premiums written; if in excess of $6 million, the figure is $1.2 million plus 15% of net premiums written in excess of $6 million, or (iii) 15% of net discounted aggregate loss and loss expense provisions and other insurance reserves, or (iv) 25% of that insurers applicable enhanced capital requirement reported at the end of its relevant year.
In addition, as a Class C long-term insurer, AGRO is required, with respect to its long-term business, to maintain a minimum solvency margin equal to the greater of $500,000 or 1.5% of its assets. For the purpose of this calculation, assets are defined as the total assets pertaining to its long-term business reported on the balance sheet in the relevant year less the amounts held in a segregated account. AGRO is also required to keep its accounts in respect of its long-term business separate from any accounts kept in respect of any other business and all receipts of its long-term business form part of its long-term business fund.
Each of AG Re and AGRO is required to maintain available statutory capital and surplus at a level equal to or in excess of its applicable enhanced capital requirement, which is established by reference to either its BSCR model or an approved internal capital model. The BSCR model is a risk-based capital model which provides a method for determining an insurer's capital requirements (statutory capital and surplus) by taking into account the risk characteristics of different aspects of the insurer's business. The BSCR formula establish capital requirements for eight categories of risk: fixed income investment risk, equity investment risk, interest rate/liquidity risk, premium risk, reserve risk, credit risk, catastrophe risk and operational risk. For each category, the capital requirement is determined by applying factors to asset, premium, reserve, creditor, probable maximum loss and operation items, with higher factors applied to items with greater underlying risk and lower factors for less risky items.
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While not specifically referred to in the Insurance Act, the Authority has also established a target capital level ("TCL") for each insurer subject to an enhanced capital requirement equal to 120% of its enhanced capital requirement. While such an insurer is not currently required to maintain its statutory capital and surplus at this level, the TCL serves as an early warning tool for the Authority and failure to maintain statutory capital at least equal to the TCL will likely result in increased regulatory oversight.
For each insurer subject to an enhanced capital requirement, the Authority has introduced a three-tiered capital system designed to assess the quality of capital resources that a company has available to meet its capital requirements. Under this system, all of an insurer's capital instruments will be classified as either basic or ancillary capital which in turn will be classified into one of three tiers based on their “loss absorbency” characteristics. Highest quality capital is classified as Tier 1 Capital; lesser quality capital is classified as either Tier 2 Capital or Tier 3 Capital. Under this regime, up to certain specified percentages of Tier 1, Tier 2 and Tier 3 Capital (determined by registration classification) may be used to support the company's minimum solvency margin, enhanced capital requirement and TCL.
Restrictions on Dividends and Distributions
The Insurance Act limits the declaration and payment of dividends and other distributions by AG Re and AGRO.
Under the Insurance Act:
• | The minimum share capital must be always issued and outstanding and cannot be reduced. For AG Re, which is registered as a Class 3B insurer, the minimum share capital is $120,000. For AGRO, which is registered both as a Class 3A and a Class C long-term insurer, the minimum share capital is $370,000. |
• | With respect to the distribution (including repurchase of shares) of any share capital, contributed surplus or other statutory capital: |
(a) | any such distribution that would reduce AG Re's or AGRO's total statutory capital by 15% or more of their respective total statutory capital as set out in their previous year's financial statements requires the prior approval of the Authority. Any application for such approval must include an affidavit stating that the company will continue to meet the required margins; and |
(b) | as a Class C long-term insurer, AGRO may not use the funds allocated to its long-term business fund, directly or indirectly, for any purpose other than a purpose of its long-term business except in so far as such payment can be made out of any surplus certified by AGRO's approved actuary to be available for distribution otherwise than to policyholders; |
• | With respect to the declaration and payment of dividends: |
(a) | each of AG Re and AGRO is prohibited from declaring or paying any dividends during any financial year if it is in breach of its solvency margin, minimum liquidity ratio or enhanced capital requirement, or if the declaration or payment of such dividends would cause such a breach (if it has failed to meet its minimum solvency margin or minimum liquidity ratio on the last day of any financial year, the insurer will be prohibited, without the approval of the Authority, from declaring or paying any dividends during the next financial year). Dividends, are paid out of each insurer's statutory surplus and, therefore, dividends cannot exceed such surplus. See "—Minimum Solvency Margin and Enhanced Capital Requirements" above and "—Minimum Liquidity Ratio" below; |
(b) | an insurer which at any time fails to meet its minimum solvency margin or comply with the enhanced capital requirement may not declare or pay any dividend until the failure is rectified, and also in such circumstances the insurer must report, within 14 days after becoming aware of its failure or having reason to believe that such failure has occurred, to the Authority in writing giving particulars of the circumstances leading to the failure and giving a plan detailing the manner, specific actions to be taken and time frame in which the insurer intends to rectify the failure. A failure to comply with the enhanced capital requirement will also result in the insurer furnishing certain other information to the Authority within 45 days after becoming aware of its failure or having reason to believe that such failure has occurred; |
(c) | as a Class 3B insurer, AG Re may not declare or pay, in any financial year, dividends of more than 25% of its total statutory capital and surplus (as set out on its previous year's financial statements) unless it files (at least |
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seven days before payment of such dividends) with the Authority an affidavit stating that it will continue to meet the required margins; and
(d) | as a Class C long-term insurer, AGRO may not declare or pay a dividend to any person other than a policyholder unless the value of the assets of its long-term business fund, as certified by AGRO's approved actuary, exceeds the extent (as so certified) of the liabilities of AGRO's long-term business, and the amount of any such dividend shall not exceed the aggregate of (1) that excess; and (2) any other funds properly available for the payment of dividends being funds arising out of AGRO's business other than its long-term business. |
The Companies Act also limits the declaration and payment of dividends and other distributions by Bermuda companies such as AGL and its Bermuda subsidiaries (including AG Re and AGRO). Such companies may only declare and pay a dividend or make a distribution out of contributed surplus (as understood under the Companies Act) if there are reasonable grounds for believing that the company is and after the payment will be able to meet and pay its liabilities as they become due and the realizable value of the company's assets will not be less than its liabilities. The Companies Act also regulates and restricts the reduction and return of capital and paid in share premium, including the repurchase of shares and imposes minimum issued and outstanding share capital requirements.
Based on the limitations above, in 2015 AG Re has the capacity to (i) make capital distributions in an aggregate amount up to $127 million without the prior approval of the Authority and (ii) declare and pay dividends in an aggregate amount up to the limit of its outstanding statutory surplus, which is $271 million. Such dividend capacity may be further limited by the actual amount of AG Re’s unencumbered assets, which amount changes from time to time due in part to collateral posting requirements. As of December 31, 2014, AG Re had unencumbered assets of approximately $651 million. AG Re declared and paid dividends of $82 million, $144 million and $151 million during 2014, 2013 and 2012, respectively, to AGL. For more information concerning AG Re’s capacity to pay dividends and or other distributions, see Note 12, Insurance Company Regulatory Requirements, of the Financial Statements and Supplementary Data. The Company does not expect AGRO to declare or pay any dividends or other distributions at this time.
Minimum Liquidity Ratio
The Insurance Act provides a minimum liquidity ratio for general business. An insurer engaged in general business is required to maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate, investment income due and accrued, accounts and premiums receivable, reinsurance balances receivable and funds held by ceding reinsurers. There are certain categories of assets which, unless specifically permitted by the Authority, do not automatically qualify as relevant assets, such as unquoted equity securities, investments in and advances to affiliates and real estate and collateral loans.
The relevant liabilities are total general business insurance reserves and total other liabilities less deferred income tax and sundry liabilities (by interpretation, those not specifically defined) and letters of credit and corporate guarantees.
Insurance Code of Conduct
Each of AG Re and AGRO is subject to the Insurance Code of Conduct, which establishes duties, standards, procedures and sound business principles which must be complied with by all insurers registered under the Insurance Act. Failure to comply with the requirements under the Insurance Code of Conduct will be a factor taken into account by the Authority in determining whether an insurer is conducting its business in a sound and prudent manner as prescribed by the Insurance Act. Such failure to comply with the requirements of the Insurance Code of Conduct could result in the Authority exercising its powers of intervention and investigation and will be a factor in calculating the operational risk charge applicable in accordance with the insurer's BSCR model.
Certain Other Bermuda Law Considerations
Although AGL is incorporated in Bermuda, it is classified as a non-resident of Bermuda for exchange control purposes by the Authority. Pursuant to its non-resident status, AGL may engage in transactions in currencies other than Bermuda dollars and there are no restrictions on its ability to transfer funds (other than funds denominated in Bermuda dollars) in and out of Bermuda or to pay dividends to U.S. residents who are holders of its common shares.
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Under Bermuda law, "exempted" companies are companies formed for the purpose of conducting business outside Bermuda from a principal place of business in Bermuda. As an "exempted" company, AGL (as well as each of AG Re and AGRO) may not, without the express authorization of the Bermuda legislature or under a license or consent granted by the Minister of Education and Economic Development, participate in certain business and other transactions, including: (1) the acquisition or holding of land in Bermuda (except that held by way of lease or tenancy agreement which is required for its business and held for a term not exceeding 50 years, or which is used to provide accommodation or recreational facilities for its officers and employees and held with the consent of the Bermuda Minister of Education and Economic Development, for a term not exceeding 21 years), (2) the taking of mortgages on land in Bermuda to secure a principal amount in excess of $50,000 unless the Minister of Education and Economic Development consents to a higher amount, and (3) the carrying on of business of any kind or type for which it is not duly licensed in Bermuda, except in certain limited circumstances, such as doing business with another exempted undertaking in furtherance of AGL's business carried on outside Bermuda.
The Bermuda government actively encourages foreign investment in "exempted" entities like AGL that are based in Bermuda, but which do not operate in competition with local businesses. AGL is not currently subject to taxes computed on profits or income or computed on any capital asset, gain or appreciation. Bermuda companies pay, as applicable, annual government fees, business fees, payroll tax and other taxes and duties. See "—Tax Matters—Taxation of AGL and Subsidiaries—Bermuda."
Special considerations apply to the Company's Bermuda operations. Under Bermuda law, non-Bermudians, other than spouses of Bermudians and individuals holding permanent resident certificates or working resident certificates, are not permitted to engage in any gainful occupation in Bermuda without a work permit issued by the Bermuda government. A work permit is only granted or extended if the employer can show that, after a proper public advertisement, no Bermudian, spouse of a Bermudian or individual holding a permanent resident certificate or working resident certificate is available who meets the minimum standards for the position. A waiver from advertising is automatically granted in respect of any chief executive officer position and other chief officer positions. The employer can also make a request for a waiver from the requirement to advertise in certain other cases, as expressed in the Bermuda government's work permit policies. Currently, all of the Company's Bermuda based professional employees who require work permits have been granted work permits by the Bermuda government.
United Kingdom
This section concerns AGE and its affiliates, Assured Guaranty (UK) Ltd. ("AGUK") and Assured Guaranty Finance Overseas Ltd (“AGFOL”), each of which is regulated in the U.K., as well as Assured Guaranty Credit Protection Ltd. ("AGCPL"), which is an authorized representative of AGE. AGUK is a U.K. insurance company that the Company elected to place into runoff.
General
Financial services relating to deposits, insurance, investments and certain other financial products fall under the U.K.'s Financial Services and Markets Act 2000 (“FSMA”), and the entities that provide them are authorized and regulated by the PRA and the Financial Conduct Authority ("FCA"). In addition, the regulatory regime in the U.K. must be consistent with relevant European Union (“EU”) legislation, which is either directly applicable in, or must be implemented into national law by, all EU member states. Key EU legislation includes the Markets in Financial Instruments Directive (“MiFID”), which harmonizes the regulatory regime for investment services and activities across the EEA, the Insurance Directives, which harmonize the regulatory regime for, respectively, life (long term) and non-life (general) insurance and the Capital Requirements Directive and Capital Requirements Regulation (together, "CRD IV"), which harmonizes the regulatory regime for credit institutions. The Capital Adequacy Directive (“CAD”) contains capital requirements for MiFID firms.
Under FSMA, effecting or carrying out contracts of insurance, within a class of general or long-term insurance, by way of business in the U.K., each constitute a “regulated activity” requiring authorization. An authorized insurance company must have permission for each class of insurance business it intends to write.
The PRA and the FCA were established on April 1, 2013 and comprise the competent regulatory authorities responsible for financial regulation in the U.K. These two new regulatory bodies cover the following areas:
• | the PRA, a subsidiary of the Bank of England, is responsible for prudential regulation of key systemically important firms (which includes insurance companies, among others), and |
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• | the FCA is responsible for the prudential regulation of all non-PRA firms, the conduct of business regulation of all firms and the regulation of market conduct. |
While the two regulators coordinate and cooperate in some areas, they have separate and independent mandates and separate rule-making and enforcement powers. AGE and AGUK are regulated by both the PRA and the FCA.
The PRA carries out the prudential supervision of insurance companies through a variety of methods, including the collection of information from statistical returns, review of accountants' reports, visits to insurance companies and regular formal interviews. The PRA takes a risk-based approach to the supervision of insurance companies.
The PRA's rules are intended to align capital requirements with the risk profile of each insurance company and ensure adequate diversification of an insurer's or reinsurer's exposures to any credit risks of its reinsurers. AGE has calculated its minimum required capital according to the PRA's individual capital adequacy criteria and is in compliance.
The PRA applies threshold conditions, which insurers must meet, and against which the PRA assesses them on a continuous basis. These conditions are that:
• | an insurer's head office, and in particular its mind and management, must be in the United Kingdom if it is incorporated in the United Kingdom; |
• | an insurer's business must be conducted in a prudent manner — in particular, the insurer must maintain appropriate financial and non-financial resources; |
• | the insurer must be fit and proper, and be appropriately staffed; and |
• | the insurer and its group must be capable of being effectively supervised. |
The PRA supervises insurers to judge whether they are acting in a manner consistent with safety and soundness and appropriate policyholder protection, and so whether they meet, and are likely to continue to meet, the threshold conditions. It weights its supervision towards those issues and those insurers that, in its judgment, pose the greatest risk to its objectives. It is forward-looking, assessing its objectives not just against current risks, but also against those that could plausibly arise further ahead and will rely significantly on the judgment of its supervisors. Its risk assessment framework looks at the potential impact of failure of the insurer, its risk context and mitigating factors. Solvency II (discussed below) will bring further changes to the supervisory framework for insurers. The Company continues to consult with the PRA on the implementation of Solvency II and the Company believes its plans are consistent with Solvency II requirements.
Position of U.K. Regulated Entities within the AGL Group
AGE is authorized to effect and carry out certain classes of general insurance, specifically: classes 14 (credit), 15 (suretyship) and 16 (miscellaneous financial loss) for eligible counterparties and professional clients only (i.e., not retail clients). This scope of permission is sufficient to enable AGE to effect and carry out financial guaranty insurance and reinsurance. The insurance and reinsurance businesses of AGE are subject to close supervision by the PRA. AGE also has permission to arrange and advise on transactions it guarantees, and to take deposits in the context of its insurance business.
Following the Company's decision in 2010 to place AGUK into run-off, the Company has been utilizing AGE as the entity from which to write business in the EEA. It was agreed between management and the then regulator, the Financial Services Authority ("FSA U.K."), that any new business written by AGE would be guaranteed using a co-insurance structure pursuant to which AGE would co-insure municipal and infrastructure transactions with AGM, and structured finance transactions with AGC. AGE must obtain the approval of the PRA before it can guarantee any new structured finance transaction. AGE's financial guaranty will cover a proportionate share (expected to be approximately 3 to 10%) of the total exposure, and AGM or AGC, as the case may be, will guarantee the remaining exposure under the transaction (subject to compliance with EEA licensing requirements). AGM or AGC, as the case may be, will also issue a second-to-pay guaranty to cover AGE's financial guarantee. AGE also is the principal of AGCPL. AGCPL is not PRA or FCA authorized, but is an appointed representative of AGE. This means AGCPL can carry on advising and arranging activities without a license, because AGE has regulatory responsibility for it.
AGFOL, a subsidiary of AGL, is authorized by the FCA to carry out designated investment business activities in that it may “advise on investments (except on pension transfers and pension opt outs)” relating to most investment instruments. In addition, it may arrange or bring about transactions in investments and make “arrangements with a view to transactions in
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investments.” In all cases, it may deal only with clients who are eligible counterparties or professional customers (so no retail clients), or, when arranging in relation to insurance contracts, commercial customers. It should be noted that AGFOL is not authorized as an insurer and does not itself take risk in the transactions it arranges or places, and may not hold funds on behalf of its customers. AGFOL's permissions also allow it to introduce business to AGC and AGM, so that AGFOL can arrange financial guaranties underwritten by AGC and AGM, even though AGFOL's role will be limited to acting as a pure introducer of business to AGC and AGM. AGFOL is an “Exempt CAD” firm: although it is a MiFID investment firm, it does not have to comply with the CAD. Its activities are limited to receiving and transmitting orders and giving investment advice and it cannot hold client money.
AGCPL is subject to the requirements of Regulation (EU) No 648/2012 of the European Parliament and of the Council of July 4, 2012 on OTC derivatives, central counterparties and trade repositories ("EMIR") which, as a European regulation, is directly applicable in all the member states of the European Union. AGCPL has notified the European Securities and Markets Authority ("ESMA") and the FCA of its status under EMIR as a non-financial counterparty which has exceeded the clearing threshold (an “NFC+”) as described in Article 10 of EMIR. As an NFC+, AGCPL is subject to certain requirements under EMIR with respect to its portfolio of derivative contracts including recordkeeping and risk mitigation techniques. Certain requirements have been applicable since March 15, 2013 (timely confirmations and daily valuations), while others have been applicable since September 15, 2013 (dispute resolution, portfolio reconciliation and portfolio compression requirements). In addition, AGCPL is now subject to certain reporting requirements under EMIR with respect to its outstanding portfolio of derivative contracts. The start date in respect of the reporting obligation was February 12, 2014, with a ninety day grace period which applied to the reporting of derivative contracts which were outstanding before August 16, 2012 and which were still outstanding on February 12, 2014. Because all of AGCPL’s outstanding derivative contracts fell within this category, AGCPL has not been required to report its derivative contracts since mid-May 2014. The EMIR provisions which require daily reporting of collateral (including mark to market valuations) have been applicable since August 11, 2014 and apply to NFC+s. Currently, AGCPL does not post collateral under its deals and is therefore not required to comply with the requirement. However, should it post collateral in the future the collateral reporting requirements under EMIR will apply to it. AGCPL is the only European entity within the AGL group which has entered into derivative contracts and as such it is the only entity in the group which is directly subject to EMIR. The Company is aware that circumstances exist in which EMIR may apply directly to non-European entities when transacting derivatives, but has determined that these circumstances do not apply to the non-European entities in AGL’s group.
Solvency Requirements
The Prudential Sourcebooks require that non-life insurance companies such as AGUK and AGE maintain a margin of solvency at all times in respect of the liabilities of the insurance company, the calculation of which depends on the type and amount of insurance business a company writes. The method of calculation of the solvency margin (known as the minimum capital requirement) is set out in the Prudential Sourcebooks, and for these purposes, the insurer's assets and liabilities are subject to specified valuation rules. If and to the extent that the premiums it collects for specified categories of insurance, such as credit and property, exceed certain specified minimum thresholds, a non-life insurance company must have extra technical provisions, called an equalization reserve, in addition to its minimum capital requirements. The purpose of the equalization reserve, calculated in accordance with the Prudential Sourcebooks, is to ensure that insurers retain additional assets to provide some extra protection against uncertainty as to the amount of claims.
The Prudential Sourcebooks also require that AGUK and AGE calculate and share with the PRA their “enhanced capital requirement” based on risk-weightings applied to assets held and lines of business written. In 2007, the FSA U.K. replaced the individual capital assessment for financial guaranty insurers with a FG Benchmark capital adequacy model devised by the FSA U.K. Should the level of capital of AGUK or AGE fall below the capital requirement as indicated by the FG Benchmark, the PRA may require the Company to undertake further work, following which Individual Capital Guidance may result. Failure to maintain capital at least equal to the minimum capital requirement in the FG Benchmark Model is one of the grounds on which the wide powers of intervention conferred upon the PRA may be exercised.
The European Union's Solvency II Directive (Directive 2009/138/EC), which itself is to be amended by the proposed Omnibus II Directive (collectively, “Solvency II”), is currently due to be implemented on January 1, 2016. The solvency requirements described above will be replaced at that point. Among other things, Solvency II introduces a revised risk-based prudential regime which includes the following "Pillar 1" regulatory capital rules:
• | assets and liabilities are generally to be valued at their market value; |
• | the amount of required economic capital is intended to ensure, with a probability of 99.5%, that regulated firms are able to meet their obligations to policyholders and beneficiaries over the following 12 months; and |
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• | reinsurance recoveries will be treated as a separate asset (rather than being netted against the underlying insurance liabilities). |
In many instances, Solvency II is expected to require insurers to maintain a somewhat increased amount of capital to satisfy the new solvency capital requirements. AGE and AGUK have agreed with the PRA that they will use the "Standard Formula" prescribed by Solvency II for calculation of their capital requirements.
In anticipation of Solvency II, the PRA has issued a Supervisory Statement (“Solvency II: applying EIOPA's preparatory guidelines to PRA-authorised firms”, Supervisory Statement 4/13, dated December 12, 2013) requiring certain information to be submitted to it before the 2016 commencement date. AGE and AGUK are among the firms required to submit information to the PRA under this Supervisory Statement. The first responses are due on July 1, 2015. The PRA and FCA are in the process of implementing the Solvency rules into UK law. This must be done by April 1, 2015, to become effective on January 1, 2016.
In addition, a U.K. insurer (which includes a company conducting only reinsurance business) is required to perform and submit to the PRA a group capital adequacy return in respect of its ultimate insurance parent. For groups with an EEA insurance parent, the calculation must show a positive result. AGE and AGUK do not have an EEA insurance parent and, accordingly, do not need to comply with this requirement. However, they do still need to report to the PRA on group capital adequacy at the level of the ultimate insurance parent outside the EEA and, if the report at that level raises concerns, the PRA may take regulatory action.
Further, an insurer is required to report in its annual returns to the PRA all material connected-party transactions (such as intra-group reinsurance whose value is more than the sum of Euro 20,000 and 5% of the insurer's liabilities arising from its general insurance business, net of reinsurance).
Restrictions on Dividend Payments
U.K. company law prohibits each of AGE and AGUK from declaring a dividend to its shareholders unless it has “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the U.K. insurance regulatory laws impose no statutory restrictions on a general insurer's ability to declare a dividend, the PRA's capital requirements may in practice act as a restriction on dividends. The Company does not expect AGE or AGUK to distribute any dividends at this time.
Reporting Requirements
U.K. insurance companies must prepare their financial statements under the Companies Act 2006, which requires the filing with Companies House of audited financial statements and related reports. In addition, U.K. insurance companies are required to file regulatory returns with the PRA, which include a revenue account, a profit and loss account and a balance sheet in prescribed forms. Under the Prudential Sourcebooks, audited regulatory returns must be filed with the PRA within two months and 15 days of the financial year end (or three months where the delivery of the return is made electronically). As noted above, AGE and AGUK also will submit information to the PRA pursuant to Supervisory Statement 4/13, in anticipation of Solvency II requirements. From the effective date of Solvency II (anticipated to be January 1, 2016), the reporting requirements for UK insurance companies will be modified by that Directive and AGE and AGUK will be required to produce certain key reports including an annual Solvency and Financial Condition Report (“SFCR”) and an Own Risk and Solvency Assessment (“ORSA”), the latter as part of the so-called “Pillar 2” individual capital assessment requirements. It is expected that the SFCR will take the place of existing regulatory returns.
Pillar 2 is based on a self-assessment methodology and calculates capital resources and requirements on an economic basis. The PRA will review each firm’s ORSA and then consider whether in its view the firm needs to hold capital in excess of its Pillar 1 capital (see “Solvency Requirements” above) and, if so, will impose a “capital add-on”. The prescribed information to be contained in the ORSA, as well as the frequency with which the assessment must be carried out, are still subject to guidance to be issued by the European Insurance and Occupational Pensions Authority (“EIOPA”) which has recently consulted on these questions.
Supervision of Management
Individuals who perform one or more “controlled functions” such as significant influence functions or the customer function within authorized firms must be approved by PRA or FCA (as appropriate) to carry out that function. The management of insurance companies falls within the scope of significant influence functions, which require approval from the PRA. Individuals performing these functions are “Approved Persons” for the purpose of Part V of FSMA and staff performing these
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specified “controlled functions” within an authorized firm must be approved by the PRA. The UK regulators are currently consulting on changes to this aspect of the supervisory regime. Specifically, the PRA is consulting on a proposed “Senior Insurance Managers Regime” (“Senior insurance managers regime: a new regulatory framework for individuals”, Consultation Paper 26/14, dated November 26, 2014) which would effectively implement the high level requirements on governance and fitness and propriety of certain individuals contained in Solvency II. Such changes, when implemented, may result in further or different individuals requiring authorization from the regulators or needing approval from the firm.
Change of Control
Under FSMA, when a person decides to acquire or increase “control” of a U.K. authorized firm (including an insurance company) they must give the PRA notice in writing before making the acquisition. The PRA has up to 60 working days (without including any period of interruption) in which to assess a change of control case. Any person (a company or individual) that directly or indirectly acquires 10% or 20% (depending on the type of firm, the “Control Percentage Threshold”) or more of the shares, or is entitled to exercise or control the exercise of the Control Percentage Threshold or more of the voting power, in a U.K. authorized firm or its parent undertaking is considered to “acquire control” of the authorized firm. Broadly speaking, the 10% threshold applies to banks, insurers and reinsurers (but not brokers) and MiFID investment firms, and the 20% threshold to insurance brokers and certain other firms that are non-directive firms.
Intervention and Enforcement
The PRA has extensive powers to intervene in the affairs of an authorized firm, culminating in the sanction of the suspension of authorization to carry on a regulated activity. The PRA can also vary or cancel a firm's permissions under its own initiative if it considers that the firm is failing, or is likely to fail, to satisfy the Threshold Conditions. FSMA gives the PRA significant investigation and enforcement powers. It also gives the PRA a rule-making power, under which it makes the various rules that constitute its Handbook of Rules.
The PRA also has the power to prosecute criminal offenses arising under FSMA, and the FCA has the power to prosecute offenses under FSMA and to prosecute insider dealing under Part V of the Criminal Justice Act of 1993, and breaches by authorized firms of money laundering and terrorist financing regulations.
“Passporting”
EU directives allow AGFOL, AGUK and AGE to conduct business in EU states other than the U.K. where they are authorized by the PRA or FCA under a single market directive. This right extends to the EEA. A firm taking advantage of a right under a single market directive to conduct business in another EEA state can rely on its "home state" authorization. This ability to operate in other jurisdictions of the EEA on the basis of home state authorization and supervision is sometimes referred to as “passporting.” Passporting is not applicable to firms not authorized in the EEA, such as AGM and AGC. Accordingly, the co-insurance model described above cannot be “passported” throughout the EEA. Instead, it is a question of local law in each EEA member state as to whether AGM's or AGC’s participation in a co-insurance structure, protecting insureds or risks located in that jurisdiction, would amount to the conduct of insurance business in that jurisdiction.
Fees and Levies
Each of AGUK, AGE and AGFOL is subject to regulatory fees and levies based on its gross premium income and gross technical liabilities. These fees are collected by the FCA (though they relate to regulation by both the PRA and the FCA). The PRA also requires authorized firms, including authorized insurers, to participate in an investors' protection fund, known as the Financial Services Compensation Scheme. The Financial Services Compensation Scheme was established to compensate consumers of financial services firms, including the buyers of insurance, against failures in the financial services industry. Eligible claimants (identified in the Compensation Sourcebook of the PRA Handbook) may be compensated by the Financial Services Compensation Scheme when an authorized insurer is unable, or likely to be unable, to satisfy policyholder claims. General insurance in class 14 (credit) is not protected by the Financial Services Compensation Scheme, nor is reinsurance in any class; however, other direct insurance classes written by AGUK and AGE are covered (namely, classes 15 (suretyship) and 16 (miscellaneous financial loss)).
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Material Contracts
AGE’s New York affiliate, AGM, currently provides support to AGE, through a quota share and excess of loss reinsurance agreement (the “Reinsurance Agreement”) and a net worth maintenance agreement (the "Net Worth Agreement"). Such agreements replace and supersede the second amended and restated quota share and stop loss reinsurance agreement and the second amended and restated net worth maintenance agreement, respectively, previously in place between the parties. For transactions closed prior to 2011, AGE typically guaranteed all of the guaranteed obligations directly and the Company reinsured under the quota share cover of the Reinsurance Agreement approximately 92% of AGE's retention after cessions to other reinsurers. In 2011, AGE and AGM implemented a co-guarantee structure pursuant to which (i) AGE directly guarantees a portion of the guaranteed obligations in an amount equal to what would have been AGE's pro rata retention percentage under the quota share cover, (ii) AGM directly guarantees the balance of the guaranteed obligations, and (iii) AGM also provides a second-to-pay guarantee for AGE's portion of the guaranteed obligations. AGM's ability to provide such direct guaranties outside of the U.K. is uncertain. See "Passporting" above.
Under the excess of loss cover of the Reinsurance Agreement, AGM will pay AGE quarterly the amount by which (i) the sum of (a) AGE’s incurred losses calculated in accordance with UK GAAP as reported by AGE in its financial returns filed with the PRA and (b) AGE’s paid losses and loss adjustment expenses, in both cases net of all other performing reinsurance, including the reinsurance provided by the Company under the quota share cover of the Reinsurance Agreement, exceeds (ii) an amount equal to (a) AGE’s capital resources under U.K. law minus (b) the greatest of the amounts as may be required by the PRA as a condition for AGE to maintain its authorization to carry on a financial guarantee business in the U.K. In addition, the Reinsurance Agreement permits AGE to terminate the Reinsurance Agreement upon the following events: a downgrade of AGM’s ratings by Moody’s below Aa3 or by S&P below AA- if the company fails to restore its rating(s) to the required level within a prescribed period of time; AGM's insolvency; failure by AGM to maintain the minimum capital required by its domiciliary jurisdiction; or AGM filing a petition in bankruptcy, going into liquidation or rehabilitation or having a receiver appointed. The Reinsurance Agreement also provides that no amounts are owing under the excess of loss cover (or the stop loss cover of the second amended and restated quota share and stop loss reinsurance agreement previously in place between the parties) with respect to any quarter ending prior to April 1, 2014.
The quota share and excess loss covers each exclude transactions guaranteed by AGE on or after July 1, 2009 that are not municipal, utility, project finance or infrastructure risks or similar types of risks.
The Reinsurance Agreement also contemplates the establishment of collateral by AGM to support its reinsurance obligations to AGE. In December 2014, to satisfy a new PRA requirement that AGM post collateral to support its reinsurance obligations to AGE, AGM and AGE amended the Reinsurance Agreement to incorporate the PRA’s requirement. Pursuant to such amended Reinsurance Agreement, AGM’s collateral requirement will be measured as of the end of each calendar quarter by (i) using the PRA’s FG Benchmark Model to calculate at the 99.5% confidence interval the losses expected to be borne collectively by AGE’s three affiliated reinsurers, AGM, AG Re and AGRO; (ii) deducting from such calculation AGE’s capital resources under such model; and (iii) requiring AGM, AG Re and AGRO collectively to maintain collateral equal to fifty percent (50%) of such difference, i.e., the excess of AGM’s, AG Re’s and AGRO’s assumed modeled losses over AGE’s capital resources. The FG Benchmark Model is the model currently used by the PRA to determine the capital adequacy of UK financial guaranty companies. It broadly adopts Basel II’s risk weighting approach for setting bank capital requirements, but with certain modifications to account for differences between banks and financial guarantors. In December 2014, AGM and AGE also entered into a related trust agreement pursuant to which AGM, prior to year-end, established, and deposited assets into, a reinsurance trust account for the benefit of AGE to satisfy the PRA’s collateral requirement as of September 30, 2014, as measured in accordance with such amended Reinsurance Agreement. The PRA has also indicated it will require collateral to be posted to support intercompany reinsurance obligations to AGUK. The PRA has not determined the amount of such collateral yet.
Pursuant to the Net Worth Agreement, AGM is obligated to cause AGE to maintain capital resources equal to 110% of the greatest of the amounts as may be required by the PRA as a condition for AGE to maintain its authorization to carry on a financial guarantee business in the U.K., provided that AGM's contributions (a) do not exceed 35% of AGM's policyholders' surplus on an accumulated basis as determined by the laws of the State of New York, and (b) are in compliance with Section 1505 of the New York Insurance Law. AGM has never been required to make any contributions to AGE's capital under the current Net Worth Agreement or the prior net worth maintenance agreement.
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Tax Matters
Taxation of AGL and Subsidiaries
Bermuda
Under current Bermuda law, there is no Bermuda income, corporate or profits tax or withholding tax, capital gains tax or capital transfer tax payable by AGL or its Bermuda subsidiaries. AGL, AG Re and AGRO have each obtained from the Minister of Finance under the Exempted Undertakings Tax Protection Act 1966, as amended, an assurance that, in the event that Bermuda enacts legislation imposing tax computed on profits, income, any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance, then the imposition of any such tax shall not be applicable to AGL, AG Re or AGRO or to any of their operations or their shares, debentures or other obligations, until March 31, 2035. This assurance is subject to the proviso that it is not to be construed so as to prevent the application of any tax or duty to such persons as are ordinarily resident in Bermuda, or to prevent the application of any tax payable in accordance with the provisions of the Land Tax Act 1967 or otherwise payable in relation to any land leased to AGL, AG Re or AGRO. AGL, AG Re and AGRO each pays annual Bermuda government fees, and AG Re and AGRO pay annual insurance license fees. In addition, all entities employing individuals in Bermuda are required to pay a payroll tax and there are other sundry taxes payable, directly or indirectly, to the Bermuda government.
United States
AGL has conducted and intends to continue to conduct substantially all of its foreign operations outside the U.S. and to limit the U.S. contacts of AGL and its foreign subsidiaries (except AGRO and AGE, which have elected to be taxed as U.S. corporations) so that they should not be engaged in a trade or business in the U.S. A foreign corporation, such as AG Re, that is deemed to be engaged in a trade or business in the United States would be subject to U.S. income tax at regular corporate rates, as well as the branch profits tax, on its income which is treated as effectively connected with the conduct of that trade or business, unless the corporation is entitled to relief under the permanent establishment provision of an applicable tax treaty, as discussed below. Such income tax, if imposed, would be based on effectively connected income computed in a manner generally analogous to that applied to the income of a U.S. corporation, except that a foreign corporation would generally be entitled to deductions and credits only if it timely files a U.S. federal income tax return. AGL, AG Re and certain of the other foreign subsidiaries have and will continue to file protective U.S. federal income tax returns on a timely basis in order to preserve the right to claim income tax deductions and credits if it is ever determined that they are subject to U.S. federal income tax. The highest marginal federal income tax rates currently are 35% for a corporation's effectively connected income and 30% for the "branch profits" tax.
Under the income tax treaty between Bermuda and the U.S. (the "Bermuda Treaty"), a Bermuda insurance company would not be subject to U.S. income tax on income found to be effectively connected with a U.S. trade or business unless that trade or business is conducted through a permanent establishment in the U.S. AG Re currently intends to conduct its activities so that it does not have a permanent establishment in the U.S.
An insurance enterprise resident in Bermuda generally will be entitled to the benefits of the Bermuda Treaty if (i) more than 50% of its shares are owned beneficially, directly or indirectly, by individual residents of the U.S. or Bermuda or U.S. citizens and (ii) its income is not used in substantial part, directly or indirectly, to make disproportionate distributions to, or to meet certain liabilities of, persons who are neither residents of either the U.S. or Bermuda nor U.S. citizens.
Foreign insurance companies carrying on an insurance business within the U.S. have a certain minimum amount of effectively connected net investment income, determined in accordance with a formula that depends, in part, on the amount of U.S. risk insured or reinsured by such companies. If AG Re or another of the Company's Bermuda subsidiaries is considered to be engaged in the conduct of an insurance business in the U.S. and is not entitled to the benefits of the Bermuda Treaty in general (because it fails to satisfy one of the limitations on treaty benefits discussed above), the Internal Revenue Code of 1986, as amended (the "Code"), could subject a significant portion of AG Re's or another of the Company's Bermuda subsidiary's investment income to U.S. income tax.
AGL, as a U.K. tax resident, would not be subject to U.S. income tax on any income found to be effectively connected with a U.S. trade or business under the income tax treaty between the U.S. and the U.K. (the “U.K. Treaty”), unless that trade or business is conducted through a permanent establishment in the United States. AGL intends to conduct its activities so that it does not have a permanent establishment in the United States.
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Foreign corporations not engaged in a trade or business in the U.S., and those that are engaged in a U.S. trade or business with respect to their non-effectively connected income are nonetheless subject to U.S. withholding tax on certain "fixed or determinable annual or periodic gains, profits and income" derived from sources within the U.S. (such as dividends and certain interest on investments), subject to exemption under the Code or reduction by applicable treaties. The standard non-treaty rate of U.S. withholding tax is currently 30%. The Bermuda Treaty does not reduce the U.S. withholding rate on U.S.-sourced investment income. The U.K. Treaty reduces or eliminates U.S. withholding tax on certain U.S. sourced investment income, including dividends from U.S. companies to U.K. resident persons entitled to the benefit of the U.K. Treaty.
The U.S. also imposes an excise tax on insurance and reinsurance premiums paid to foreign insurers with respect to risk of a U.S. person located wholly or partly within the U.S. or risks of a foreign person engaged in a trade or business in the U.S. which are located within the U.S. The rates of tax applicable to premiums paid are 4% for direct casualty insurance premiums and 1% for reinsurance premiums.
AGRO and AGE have elected to be treated as U.S. corporations for all U.S. federal tax purposes and, as such, each of AGRO and AGE, together with AGL's U.S. subsidiaries, is subject to taxation in the U.S. at regular corporate rates.
If AGRO were to pay dividends to its U.S. holding company parent and that U.S. holding company were to pay dividends to its Bermudian parent AG Re, such dividends would be subject to U.S. withholding tax at a rate of 30%.
None of AGL or its principal subsidiaries will be subject to any additional U.S. taxes, including withholding tax, as a result of AGL becoming a U.K. tax resident.
United Kingdom
In November 2013, AGL became tax resident in the U.K. AGL remains a Bermuda-based company and its administrative and head office functions will continue to be carried on in Bermuda. The AGL common shares have not changed and will continue to be listed on the New York Stock Exchange.
As a company that is not incorporated in the U.K., AGL will be considered tax resident in the U.K. only if it is “centrally managed and controlled” in the U.K. Central management and control constitutes the highest level of control of a company’s affairs. Effective November 6, 2013, the AGL board of directors intends to manage the affairs of AGL in such a way as to maintain its status as a company that is tax resident in the U.K.
As a U.K. tax resident company, AGL is subject to the tax rules applicable to companies resident in the U.K., including the benefits afforded by the U.K.’s tax treaties.
As a U.K. tax resident, AGL is required to file a corporation tax return with Her Majesty’s Revenue & Customs (“HMRC”). AGL will be subject to U.K. corporation tax in respect of its worldwide profits (both income and capital gains), subject to any applicable exemptions. The main rate of corporation tax is 21% currently; such rate which fell to 21% as of April 1, 2014 and to 20% as of April 1, 2015. AGL has also registered in the U.K. to report its value added tax (“VAT”) liability. The current rate of VAT is 20%.
Assured Guaranty does not expect that becoming U.K. tax resident will result in any material change in the group’s overall current tax charge. Assured Guaranty expects that the dividends AGL receives from its direct subsidiaries will be exempt from U.K. corporation tax due to the exemption in section 931D of the U.K. Corporation Tax Act 2009. In addition, any dividends paid by AGL to its shareholders should not be subject to any withholding tax in the U.K. The U.K. government implemented a new tax regime for “controlled foreign companies” ("CFC regime") effective January 1, 2013, stating an intention to target more accurately profits that should be subject to U.K. taxation and to improve the attractiveness of the U.K. as a location for a holding company of a multinational group. The non-U.K. resident subsidiaries intend to operate in such a manner that their profits are outside the scope of the CFC regime charge. Accordingly, Assured Guaranty does not expect any profits of non-U.K. resident members of the group to be attributed to AGL and taxed in the U.K. under the CFC regime and has obtained clearance from HMRC confirming this on the basis of current facts and intentions.
Taxation of Shareholders
Bermuda Taxation
Currently, there is no Bermuda capital gains tax, or withholding or other tax payable on principal, interest or dividends paid to the holders of the AGL common shares.
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United States Taxation
This discussion is based upon the Code, the regulations promulgated thereunder and any relevant administrative rulings or pronouncements or judicial decisions, all as in effect on the date hereof and as currently interpreted, and does not take into account possible changes in such tax laws or interpretations thereof, which may apply retroactively. This discussion does not include any description of the tax laws of any state or local governments within the U.S. or any foreign government.
The following summary sets forth the material U.S. federal income tax considerations related to the purchase, ownership and disposition of AGL's shares. Unless otherwise stated, this summary deals only with holders that are U.S. Persons (as defined below) who purchase their shares and who hold their shares as capital assets within the meaning of section 1221 of the Code. The following discussion is only a discussion of the material U.S. federal income tax matters as described herein and does not purport to address all of the U.S. federal income tax consequences that may be relevant to a particular shareholder in light of such shareholder's specific circumstances. For example, special rules apply to certain shareholders, such as partnerships, insurance companies, regulated investment companies, real estate investment trusts, financial asset securitization investment trusts, dealers or traders in securities, tax exempt organizations, expatriates, persons that do not hold their securities in the U.S. dollar, persons who are considered with respect to AGL or any of its foreign subsidiaries as "United States shareholders" for purposes of the controlled foreign corporation ("CFC") rules of the Code (generally, a U.S. Person, as defined below, who owns or is deemed to own 10% or more of the total combined voting power of all classes of AGL or the stock of any of AGL's foreign subsidiaries entitled to vote (i.e., 10% U.S. Shareholders)), or persons who hold the common shares as part of a hedging or conversion transaction or as part of a short-sale or straddle. Any such shareholder should consult their tax advisor.
If a partnership holds AGL's shares, the tax treatment of the partners will generally depend on the status of the partner and the activities of the partnership. Partners of a partnership owning AGL's shares should consult their tax advisers.
For purposes of this discussion, the term "U.S. Person" means: (i) a citizen or resident of the U.S., (ii) a partnership or corporation, created or organized in or under the laws of the U.S., or organized under any political subdivision thereof, (iii) an estate the income of which is subject to U.S. federal income taxation regardless of its source, (iv) a trust if either (x) a court within the U.S. is able to exercise primary supervision over the administration of such trust and one or more U.S. Persons have the authority to control all substantial decisions of such trust or (y) the trust has a valid election in effect to be treated as a U.S. Person for U.S. federal income tax purposes or (v) any other person or entity that is treated for U.S. federal income tax purposes as if it were one of the foregoing.
Taxation of Distributions. Subject to the discussions below relating to the potential application of the CFC, related person insurance income ("RPII") and passive foreign investment company ("PFIC") rules, cash distributions, if any, made with respect to AGL's shares will constitute dividends for U.S. federal income tax purposes to the extent paid out of current or accumulated earnings and profits of AGL (as computed using U.S. tax principles). Dividends paid by AGL to corporate shareholders will not be eligible for the dividends received deduction. To the extent such distributions exceed AGL's earnings and profits, they will be treated first as a return of the shareholder's basis in the common shares to the extent thereof, and then as gain from the sale of a capital asset.
AGL believes dividends paid by AGL on its common shares to non-corporate holders will be eligible for reduced rates of tax at the rates applicable to long-term capital gains as "qualified dividend income," provided that AGL is not a PFIC and certain other requirements, including stock holding period requirements, are satisfied.
Classification of AGL or its Foreign Subsidiaries as a Controlled Foreign Corporation. Each 10% U.S. Shareholder (as defined below) of a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during a taxable year, and who owns shares in the foreign corporation, directly or indirectly through foreign entities, on the last day of the foreign corporation's taxable year on which it is CFC, must include in its gross income for U.S. federal income tax purposes its pro rata share of the CFC's "subpart F income," even if the subpart F income is not distributed. "Subpart F income" of a foreign insurance corporation typically includes foreign personal holding company income (such as interest, dividends and other types of passive income), as well as insurance and reinsurance income (including underwriting and investment income). A foreign corporation is considered a CFC if 10% U.S. Shareholders own (directly, indirectly through foreign entities or by attribution by application of the constructive ownership rules of section 958(b) of the Code (i.e., "constructively")) more than 50% of the total combined voting power of all classes of voting stock of such foreign corporation, or more than 50% of the total value of all stock of such corporation on any day during the taxable year of such corporation. For purposes of taking into account insurance income, a CFC also includes a foreign insurance company in which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned by 10% U.S. Shareholders, on any day during the taxable year of such corporation. A "10% U.S. Shareholder" is a U.S. Person who owns (directly, indirectly through foreign
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entities or constructively) at least 10% of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. AGL believes that because of the dispersion of AGL's share ownership, provisions in AGL's organizational documents that limit voting power (these provisions are described in "Description of Share Capital") and other factors, no U.S. Person who owns shares of AGL directly or indirectly through one or more foreign entities should be treated as owning (directly, indirectly through foreign entities, or constructively), 10% or more of the total voting power of all classes of shares of AGL or any of its foreign subsidiaries. It is possible, however, that the Internal Revenue Service ("IRS") could challenge the effectiveness of these provisions and that a court could sustain such a challenge. In addition, the direct and indirect subsidiaries of AGUS are characterized as CFCs and any subpart F income generated will be included in the gross income of the applicable domestic subsidiaries in the AGL group.
The RPII CFC Provisions. The following discussion generally is applicable only if the RPII of AG Re or any other foreign insurance subsidiary that has not made an election under section 953(d) of the Code to be treated as a U.S. corporation for all U.S. federal tax purposes or are CFCs owned directly or indirectly by AGUS (each a "Foreign Insurance Subsidiary" or collectively, with AG Re, the "Foreign Insurance Subsidiaries") determined on a gross basis, is 20% or more of the Foreign Insurance Subsidiary's gross insurance income for the taxable year and the 20% Ownership Exception (as defined below) is not met. The following discussion generally would not apply for any taxable year in which the Foreign Insurance Subsidiary's gross RPII falls below the 20% threshold or the 20% Ownership Exception is met. Although the Company cannot be certain, it believes that each Foreign Insurance Subsidiary has been, in prior years of operations, and will be, for the foreseeable future, either below the 20% threshold or in compliance with the requirements of 20% Ownership Exception for each tax year.
RPII is any "insurance income" (as defined below) attributable to policies of insurance or reinsurance with respect to which the person (directly or indirectly) insured is a "RPII shareholder" (as defined below) or a "related person" (as defined below) to such RPII shareholder. In general, and subject to certain limitations, "insurance income" is income (including premium and investment income) attributable to the issuing of any insurance or reinsurance contract which would be taxed under the portions of the Code relating to insurance companies if the income were the income of a domestic insurance company. For purposes of inclusion of the RPII of a Foreign Insurance Subsidiary in the income of RPII shareholders, unless an exception applies, the term "RPII shareholder" means any U.S. Person who owns (directly or indirectly through foreign entities) any amount of AGL's common shares. Generally, the term "related person" for this purpose means someone who controls or is controlled by the RPII shareholder or someone who is controlled by the same person or persons which control the RPII shareholder. Control is measured by either more than 50% in value or more than 50% in voting power of stock applying certain constructive ownership principles. A Foreign Insurance Subsidiary will be treated as a CFC under the RPII provisions if RPII shareholders are treated as owning (directly, indirectly through foreign entities or constructively) 25% or more of the shares of AGL by vote or value.
RPII Exceptions. The special RPII rules do not apply if (i) at all times during the taxable year less than 20% of the voting power and less than 20% of the value of the stock of AGL (the "20% Ownership Exception") is owned (directly or indirectly through entities) by persons who are (directly or indirectly) insured under any policy of insurance or reinsurance issued by a Foreign Insurance Subsidiary or related persons to any such person, (ii) RPII, determined on a gross basis, is less than 20% of a Foreign Insurance Subsidiary's gross insurance income for the taxable year (the "20% Gross Income Exception), (iii) a Foreign Insurance Subsidiary elects to be taxed on its RPII as if the RPII were effectively connected with the conduct of a U.S. trade or business, and to waive all treaty benefits with respect to RPII and meet certain other requirements or (iv) a Foreign Insurance Subsidiary elects to be treated as a U.S. corporation and waive all treaty benefits and meet certain other requirements. The Foreign Insurance Subsidiaries do not intend to make either of these elections. Where none of these exceptions applies, each U.S. Person owning or treated as owning any shares in AGL (and therefore, indirectly, in a Foreign Insurance Subsidiary) on the last day of AGL's taxable year will be required to include in its gross income for U.S. federal income tax purposes its share of the RPII for the portion of the taxable year during which a Foreign Insurance Subsidiary was a CFC under the RPII provisions, determined as if all such RPII were distributed proportionately only to such U.S. Persons at that date, but limited by each such U.S. Person's share of a Foreign Insurance Subsidiary's current-year earnings and profits as reduced by the U.S. Person's share, if any, of certain prior-year deficits in earnings and profits. The Foreign Insurance Subsidiaries intend to operate in a manner that is intended to ensure that each qualifies for either the 20% Gross Income Exception or 20% Ownership Exception.
Computation of RPII. For any year in which a Foreign Insurance Subsidiary does not meet the 20% Ownership Exception or the 20% Gross Income Exception, AGL may also seek information from its shareholders as to whether beneficial owners of shares at the end of the year are U.S. Persons so that the RPII may be determined and apportioned among such persons; to the extent AGL is unable to determine whether a beneficial owner of shares is a U.S. Person, AGL may assume that such owner is not a U.S. Person, thereby increasing the per share RPII amount for all known RPII shareholders. The amount of RPII includable in the income of a RPII shareholder is based upon the net RPII income for the year after deducting related
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expenses such as losses, loss reserves and operating expenses. If a Foreign Insurance Subsidiary meets the 20% Ownership Exception or the 20% Gross Income Exception, RPII shareholders will not be required to include RPII in their taxable income.
Apportionment of RPII to U.S. Holders. Every RPII shareholder who owns shares on the last day of any taxable year of AGL in which a Foreign Insurance Subsidiary does not meet the 20% Ownership Exception or the 20% Gross Income Exception should expect that for such year it will be required to include in gross income its share of a Foreign Insurance Subsidiary's RPII for the portion of the taxable year during which the Foreign Insurance Subsidiary was a CFC under the RPII provisions, whether or not distributed, even though it may not have owned the shares throughout such period. A RPII shareholder who owns shares during such taxable year but not on the last day of the taxable year is not required to include in gross income any part of the Foreign Insurance Subsidiary's RPII.
Basis Adjustments. An RPII shareholder's tax basis in its common shares will be increased by the amount of any RPII the shareholder includes in income. The RPII shareholder may exclude from income the amount of any distributions by AGL out of previously taxed RPII income. The RPII shareholder's tax basis in its common shares will be reduced by the amount of such distributions that are excluded from income.
Uncertainty as to Application of RPII. The RPII provisions are complex and have never been interpreted by the courts or the Treasury Department in final regulations; regulations interpreting the RPII provisions of the Code exist only in proposed form. It is not certain whether these regulations will be adopted in their proposed form or what changes or clarifications might ultimately be made thereto or whether any such changes, as well as any interpretation or application of RPII by the IRS, the courts or otherwise, might have retroactive effect. These provisions include the grant of authority to the Treasury Department to prescribe "such regulations as may be necessary to carry out the purpose of this subsection including regulations preventing the avoidance of this subsection through cross insurance arrangements or otherwise." Accordingly, the meaning of the RPII provisions and the application thereof to the Foreign Insurance Subsidiaries is uncertain. In addition, the Company cannot be certain that the amount of RPII or the amounts of the RPII inclusions for any particular RPII shareholder, if any, will not be subject to adjustment based upon subsequent IRS examination. Any prospective investor which does business with a Foreign Insurance Subsidiary and is considering an investment in common shares should consult his tax advisor as to the effects of these uncertainties.
Information Reporting. Under certain circumstances, U.S. Persons owning shares (directly, indirectly or constructively) in a foreign corporation are required to file IRS Form 5471 with their U.S. federal income tax returns. Generally, information reporting on IRS Form 5471 is required by (i) a person who is treated as a RPII shareholder, (ii) a 10% U.S. Shareholder of a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during any tax year of the foreign corporation and who owned the stock on the last day of that year; and (iii) under certain circumstances, a U.S. Person who acquires stock in a foreign corporation and as a result thereof owns 10% or more of the voting power or value of such foreign corporation, whether or not such foreign corporation is a CFC. For any taxable year in which AGL determines that the 20% Gross Income Exception and the 20% Ownership Exception does not apply, AGL will provide to all U.S. Persons registered as shareholders of its shares a completed IRS Form 5471 or the relevant information necessary to complete the form. Failure to file IRS Form 5471 may result in penalties. In addition, U.S. shareholders should consult their tax advisors with respect to other information reporting requirements that may be applicable to them.
For taxable years beginning after March 18, 2010, the Code requires that any individual owning an interest in “specified foreign financial assets,” including an interest in a foreign entity (such as AGL) that is not held in an account maintained by a financial institution, the value of which in the aggregate exceeds certain thresholds, attach IRS Form 8938 to his or her tax return for the year that provides detailed disclosure of such assets. Penalties may be assessed for failure to comply. Future guidance is expected to provide that certain domestic entities would also be subject to this reporting requirement in the future.
Tax-Exempt Shareholders. Tax-exempt entities will be required to treat certain subpart F insurance income, including RPII, that is includible in income by the tax-exempt entity as unrelated business taxable income. Prospective investors that are tax exempt entities are urged to consult their tax advisors as to the potential impact of the unrelated business taxable income provisions of the Code. A tax-exempt organization that is treated as a 10% U.S. Shareholder or a RPII Shareholder also must file IRS Form 5471 in certain circumstances.
Dispositions of AGL's Shares. Subject to the discussions below relating to the potential application of the Code section 1248 and PFIC rules, holders of shares generally should recognize capital gain or loss for U.S. federal income tax purposes on the sale, exchange or other disposition of shares in the same manner as on the sale, exchange or other disposition of any other shares held as capital assets. If the holding period for these shares exceeds one year, any gain will be subject to tax
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at a current maximum marginal tax rate of 20% for individuals and 35% for corporations. Moreover, gain, if any, generally will be a U.S. source gain and generally will constitute "passive income" for foreign tax credit limitation purposes.
Code section 1248 provides that if a U.S. Person sells or exchanges stock in a foreign corporation and such person owned, directly, indirectly through foreign entities or constructively, 10% or more of the voting power of the corporation at any time during the five-year period ending on the date of disposition when the corporation was a CFC, any gain from the sale or exchange of the shares will be treated as a dividend to the extent of the CFC's earnings and profits (determined under U.S. federal income tax principles) during the period that the shareholder held the shares and while the corporation was a CFC (with certain adjustments). The Company believes that because of the dispersion of AGL's share ownership, provisions in AGL's organizational documents that limit voting power and other factors that no U.S. shareholder of AGL should be treated as owning (directly, indirectly through foreign entities or constructively) 10% of more of the total voting power of AGL; to the extent this is the case this application of Code Section 1248 under the regular CFC rules should not apply to dispositions of AGL's shares. It is possible, however, that the IRS could challenge the effectiveness of these provisions and that a court could sustain such a challenge. A 10% U.S. Shareholder may in certain circumstances be required to report a disposition of shares of a CFC by attaching IRS Form 5471 to the U.S. federal income tax or information return that it would normally file for the taxable year in which the disposition occurs. In the event this is determined necessary, AGL will provide a completed IRS Form 5471 or the relevant information necessary to complete the Form. Code section 1248 in conjunction with the RPII rules also applies to the sale or exchange of shares in a foreign corporation if the foreign corporation would be treated as a CFC for RPII purposes regardless of whether the shareholder is a 10% U.S. Shareholder or whether the 20% Ownership Exception or 20% Gross Income Exception applies. Existing proposed regulations do not address whether Code section 1248 would apply if a foreign corporation is not a CFC but the foreign corporation has a subsidiary that is a CFC and that would be taxed as an insurance company if it were a domestic corporation. The Company believes, however, that this application of Code section 1248 under the RPII rules should not apply to dispositions of AGL's shares because AGL will not be directly engaged in the insurance business. The Company cannot be certain, however, that the IRS will not interpret the proposed regulations in a contrary manner or that the Treasury Department will not amend the proposed regulations to provide that these rules will apply to dispositions of common shares. Prospective investors should consult their tax advisors regarding the effects of these rules on a disposition of common shares.
U.S. shareholders of AGL will not be subject to any additional U.S. taxes, including withholding tax, as a result of AGL becoming U.K. tax resident.
Passive Foreign Investment Companies. In general, a foreign corporation will be a PFIC during a given year if (i) 75% or more of its gross income constitutes "passive income" (the "75% test") or (ii) 50% or more of its assets produce passive income (the "50% test").
If AGL were characterized as a PFIC during a given year, each U.S. Person holding AGL's shares would be subject to a penalty tax at the time of the sale at a gain of, or receipt of an "excess distribution" with respect to, their shares, unless such person (i) is a 10% U.S. Shareholder and AGL is a CFC or (ii) made a "qualified electing fund election" or "mark-to-market" election. It is uncertain that AGL would be able to provide its shareholders with the information necessary for a U.S. Person to make a qualified electing fund election. In addition, if AGL were considered a PFIC, upon the death of any U.S. individual owning common shares, such individual's heirs or estate would not be entitled to a "step-up" in the basis of the common shares that might otherwise be available under U.S. federal income tax laws. In general, a shareholder receives an "excess distribution" if the amount of the distribution is more than 125% of the average distribution with respect to the common shares during the three preceding taxable years (or shorter period during which the taxpayer held common shares). In general, the penalty tax is equivalent to an interest charge on taxes that are deemed due during the period the shareholder owned the common shares, computed by assuming that the excess distribution or gain (in the case of a sale) with respect to the common shares was taken in equal portion at the highest applicable tax rate on ordinary income throughout the shareholder's period of ownership. The interest charge is equal to the applicable rate imposed on underpayments of U.S. federal income tax for such period. In addition, a distribution paid by AGL to U.S. shareholders that is characterized as a dividend and is not characterized as an excess distribution would not be eligible for reduced rates of tax as qualified dividend income.
For the above purposes, passive income generally includes interest, dividends, annuities and other investment income. The PFIC rules provide that income "derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business... is not treated as passive income." The PFIC provisions also contain a look-through rule under which a foreign corporation shall be treated as if it "received directly its proportionate share of the income..." and as if it "held its proportionate share of the assets..." of any other corporation in which it owns at least 25% of the value of the stock.
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The insurance income exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent such income is attributable to financial reserves in excess of the reasonable needs of the insurance business. The Company expects, for purposes of the PFIC rules, that each of AGL's insurance subsidiaries will be predominantly engaged in an insurance business and is unlikely to have financial reserves in excess of the reasonable needs of its insurance business in each year of operations. Accordingly, none of the income or assets of AGL's insurance subsidiaries should be treated as passive. Additionally, the Company expects that in each year of operations the passive income and assets of AGL's non-insurance subsidiaries will not exceed the 75% test or 50% test amounts in each year of operations with respect to the overall income and assets of AGL and its subsidiaries. Under the look-through rule AGL should be deemed to own its proportionate share of the assets and to have received its proportionate share of the income of its direct and indirect subsidiaries for purposes of the 75% test and the 50% test. As a result, the Company believes that AGL was not and should not be treated as a PFIC. The Company cannot be certain, however, as there are currently no regulations regarding the application of the PFIC provisions to an insurance company and new regulations or pronouncements interpreting or clarifying these rules may be forthcoming, that the IRS will not successfully challenge this position. Prospective investors should consult their tax advisor as to the effects of the PFIC rules.
Foreign tax credit. If U.S. Persons own a majority of AGL's common shares, only a portion of the current income inclusions, if any, under the CFC, RPII and PFIC rules and of dividends paid by AGL (including any gain from the sale of common shares that is treated as a dividend under section 1248 of the Code) will be treated as foreign source income for purposes of computing a shareholder's U.S. foreign tax credit limitations. The Company will consider providing shareholders with information regarding the portion of such amounts constituting foreign source income to the extent such information is reasonably available. It is also likely that substantially all of the "subpart F income," RPII and dividends that are foreign source income will constitute either "passive" or "general" income. Thus, it may not be possible for most shareholders to utilize excess foreign tax credits to reduce U.S. tax on such income.
Information Reporting and Backup Withholding on Distributions and Disposition Proceeds. Information returns may be filed with the IRS in connection with distributions on AGL's common shares and the proceeds from a sale or other disposition of AGL's common shares unless the holder of AGL's common shares establishes an exemption from the information reporting rules. A holder of common shares that does not establish such an exemption may be subject to U.S. backup withholding tax on these payments if the holder is not a corporation or non-U.S. Person or fails to provide its taxpayer identification number or otherwise comply with the backup withholding rules. The amount of any backup withholding from a payment to a U.S. Person will be allowed as a credit against the U.S. Person's U.S. federal income tax liability and may entitle the U.S. Person to a refund, provided that the required information is furnished to the IRS.
Changes in U.S. Federal Income Tax Law Could Materially Adversely Affect AGL or AGL's Shareholders. Legislation has been introduced from time to time in the U.S. Congress intended to eliminate certain perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the U.S. but have certain U.S. connections. For example, legislation has been introduced in Congress to limit the deductibility of reinsurance premiums paid by U.S. companies to foreign affiliates. It is possible that this or similar legislation could be introduced in and enacted by the current Congress or future Congresses that could have an adverse impact on AGL or AGL's shareholders.
Additionally, tax laws and interpretations regarding whether a company is engaged in a U.S. trade or business or whether a company is a CFC or a PFIC or has RPII are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to an insurance company. Additionally, the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying such rules may be forthcoming. The Company cannot be certain if, when or in what form such regulations or pronouncements may be provided and whether such guidance will have a retroactive effect.
United Kingdom
The following discussion is intended to be only a general guide to certain U.K. tax consequences of holding AGL common shares, under current law and the current practice of HMRC, either of which is subject to change at any time, possibly with retrospective effect. Except where otherwise stated, this discussion applies only to shareholders who are not (and have not recently been) resident or (in the case of individuals) domiciled for tax purposes in the U.K., who hold their AGL common shares as an investment and who are the absolute beneficial owners of their common shares. This discussion may not apply to certain shareholders, such as dealers in securities, life insurance companies, collective investment schemes, shareholders who are exempt from tax and shareholders who have (or are deemed to have) acquired their shares by virtue of an office or employment. Such shareholders may be subject to special rules.
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The following statements do not purport to be a comprehensive description of all the U.K. considerations that may be relevant to any particular shareholder. Any person who is in any doubt as to their tax position should consult an appropriate professional tax adviser.
AGL's Tax Residency. AGL is not incorporated in the U.K., but effective November 6, 2013, the AGL Board of Directors intends to manage the affairs of AGL in such a way as to maintain its status as a company that is tax resident in the U.K.
Dividends. Under current U.K. tax law, AGL is not required to withhold tax at source from dividends paid to the holders of the AGL common shares.
Capital gains. U.K. tax is not normally charged on any capital gains realized by non-U.K. shareholders in AGL unless, in the case of a corporate shareholder, at or before the time the gain accrues, the shareholding is used in or for the purposes of a trade carried on by the non-resident shareholder through a permanent establishment in the U.K. or for the purposes of that permanent establishment. Similarly, an individual shareholder who carries on a trade, profession or vocation in the U.K. through a branch or agency may be liable for U.K. tax on the gain if such shareholder disposes of shares that are, or have been, used, held or acquired for the purposes of such trade, profession or vocation or for the purposes of such branch or agency. This treatment applies regardless of the U.K. tax residence status of AGL.
Stamp Taxes. On the basis that AGL does not currently intend to maintain a share register in the U.K., there should be no U.K. stamp duty reserve tax on a purchase of common shares in AGL. A conveyance or transfer on sale of common shares in AGL will not be subject to U.K. stamp duty provided that the instrument of transfer is not executed in the U.K. and does not relate to any property situate, or any matter or thing done, or to be done, in the U.K.
Description of Share Capital
The following summary of AGL's share capital is qualified in its entirety by the provisions of Bermuda law, AGL's memorandum of association and its Bye-Laws, copies of which are incorporated by reference as exhibits to this Annual Report on Form 10-K.
AGL's authorized share capital of $5,000,000 is divided into 500,000,000 shares, par value U.S. $0.01 per share, of which 155,401,118 common shares were issued and outstanding as of February 23, 2015. Except as described below, AGL's common shares have no pre-emptive rights or other rights to subscribe for additional common shares, no rights of redemption, conversion or exchange and no sinking fund rights. In the event of liquidation, dissolution or winding-up, the holders of AGL's common shares are entitled to share equally, in proportion to the number of common shares held by such holder, in AGL's assets, if any remain after the payment of all AGL's debts and liabilities and the liquidation preference of any outstanding preferred shares. Under certain circumstances, AGL has the right to purchase all or a portion of the shares held by a shareholder. See "—Acquisition of Common Shares by AGL" below.
Voting Rights and Adjustments
In general, and except as provided below, shareholders have one vote for each common share held by them and are entitled to vote with respect to their fully paid shares at all meetings of shareholders. However, if, and so long as, the common shares (and other of AGL's shares) of a shareholder are treated as "controlled shares" (as determined pursuant to section 958 of the Code) of any U.S. Person and such controlled shares constitute 9.5% or more of the votes conferred by AGL's issued and outstanding shares, the voting rights with respect to the controlled shares owned by such U.S. Person shall be limited, in the aggregate, to a voting power of less than 9.5% of the voting power of all issued and outstanding shares, under a formula specified in AGL's Bye-laws. The formula is applied repeatedly until there is no U.S. Person whose controlled shares constitute 9.5% or more of the voting power of all issued and outstanding shares and who generally would be required to recognize income with respect to AGL under the Code if AGL were a controlled foreign corporation as defined in the Code and if the ownership threshold under the Code were 9.5% (as defined in AGL's Bye-Laws as a "9.5% U.S. Shareholder"). In addition, AGL's Board of Directors may determine that shares held carry different voting rights when it deems it appropriate to do so to (i) avoid the existence of any 9.5% U.S. Shareholder; and (ii) avoid adverse tax, legal or regulatory consequences to AGL or any of its subsidiaries or any direct or indirect holder of shares or its affiliates. "Controlled shares" includes, among other things, all shares of AGL that such U.S. Person is deemed to own directly, indirectly or constructively (within the meaning of section 958 of the Code). Further, these provisions do not apply in the event one shareholder owns greater than 75% of the voting power of all issued and outstanding shares.
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Under these provisions, certain shareholders may have their voting rights limited to less than one vote per share, while other shareholders may have voting rights in excess of one vote per share. Moreover, these provisions could have the effect of reducing the votes of certain shareholders who would not otherwise be subject to the 9.5% limitation by virtue of their direct share ownership. AGL's Bye-laws provide that it will use its best efforts to notify shareholders of their voting interests prior to any vote to be taken by them.
AGL's Board of Directors is authorized to require any shareholder to provide information for purposes of determining whether any holder's voting rights are to be adjusted, which may be information on beneficial share ownership, the names of persons having beneficial ownership of the shareholder's shares, relationships with other shareholders or any other facts AGL's Board of Directors may deem relevant. If any holder fails to respond to this request or submits incomplete or inaccurate information, AGL's Board of Directors may eliminate the shareholder's voting rights. All information provided by the shareholder will be treated by AGL as confidential information and shall be used by AGL solely for the purpose of establishing whether any 9.5% U.S. Shareholder exists and applying the adjustments to voting power (except as otherwise required by applicable law or regulation).
Restrictions on Transfer of Common Shares
AGL's Board of Directors may decline to register a transfer of any common shares under certain circumstances, including if they have reason to believe that any adverse tax, regulatory or legal consequences to the Company, any of its subsidiaries or any of its shareholders or indirect holders of shares or its Affiliates may occur as a result of such transfer (other than such as AGL's Board of Directors considers de minimis). Transfers must be by instrument unless otherwise permitted by the Companies Act.
The restrictions on transfer and voting restrictions described above may have the effect of delaying, deferring or preventing a change in control of Assured Guaranty.
Acquisition of Common Shares by AGL
Under AGL's Bye-Laws and subject to Bermuda law, if AGL's Board of Directors determines that any ownership of AGL's shares may result in adverse tax, legal or regulatory consequences to AGL, any of AGL's subsidiaries or any of AGL's shareholders or indirect holders of shares or its Affiliates (other than such as AGL's Board of Directors considers de minimis), AGL has the option, but not the obligation, to require such shareholder to sell to AGL or to a third party to whom AGL assigns the repurchase right the minimum number of common shares necessary to avoid or cure any such adverse consequences at a price determined in the discretion of the Board of Directors to represent the shares' fair market value (as defined in AGL's Bye-Laws).
Other Provisions of AGL's Bye-Laws
AGL's Board of Directors and Corporate Action
AGL's Bye-Laws provide that AGL's Board of Directors shall consist of not less than three and not more than 21 directors, the exact number as determined by the Board of Directors. AGL's Board of Directors consists of ten persons who are elected for annual terms.
Shareholders may only remove a director for cause (as defined in AGL's Bye-Laws) at a general meeting, provided that the notice of any such meeting convened for the purpose of removing a director shall contain a statement of the intention to do so and shall be provided to that director at least two weeks before the meeting. Vacancies on the Board of Directors can be filled by the Board of Directors if the vacancy occurs in those events set out in AGL's Bye-Laws as a result of death, disability, disqualification or resignation of a director, or from an increase in the size of the Board of Directors.
Generally under AGL's Bye-Laws, the affirmative votes of a majority of the votes cast at any meeting at which a quorum is present is required to authorize a resolution put to vote at a meeting of the Board of Directors, including one relating to a merger, acquisition or business combination. Corporate action may also be taken by a unanimous written resolution of the Board of Directors without a meeting. A quorum shall be at least one-half of directors then in office present in person or represented by a duly authorized representative, provided that at least two directors are present in person.
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Shareholder Action
At the commencement of any general meeting, two or more persons present in person and representing, in person or by proxy, more than 50% of the issued and outstanding shares entitled to vote at the meeting shall constitute a quorum for the transaction of business. In general, any questions proposed for the consideration of the shareholders at any general meeting shall be decided by the affirmative votes of a majority of the votes cast in accordance with the Bye-Laws.
The Bye-Laws contain advance notice requirements for shareholder proposals and nominations for directors, including when proposals and nominations must be received and the information to be included.
Amendment
The Bye-Laws may be amended only by a resolution adopted by the Board of Directors and by resolution of the shareholders.
Voting of Non-U.S. Subsidiary Shares
If AGL is required or entitled to vote at a general meeting of any of AG Re, AGFOL or any other of its directly held non-U.S. subsidiaries, AGL's Board of Directors shall refer the subject matter of the vote to AGL's shareholders and seek direction from such shareholders as to how they should vote on the resolution proposed by the non-U.S. subsidiary. AGL's Board of Directors in its discretion shall require substantially similar provisions are or will be contained in the bye-laws (or equivalent governing documents) of any direct or indirect non-U.S. subsidiaries other than U.K. and AGRO.
Employees
As of December 31, 2014, the Company had approximately 300 employees. None of the Company's employees are subject to collective bargaining agreements. The Company believes that employee relations are satisfactory.
Available Information
The Company maintains an Internet web site at www.assuredguaranty.com. The Company makes available, free of charge, on its web site (under assuredguaranty.com/sec-filings) the Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13 (a) or 15 (d) of the Exchange Act as soon as reasonably practicable after the Company files such material with, or furnishes it to, the SEC. The Company also makes available, free of charge, through its web site (under assuredguaranty.com/governance) links to the Company's Corporate Governance Guidelines, its Code of Conduct, AGL's Bye-Laws and the charters for its Board committees.
The Company routinely posts important information for investors on its web site (under assuredguaranty.com/company-statements and, more generally, under the Investor Information and Businesses pages). The Company uses this web site as a means of disclosing material information and for complying with its disclosure obligations under SEC Regulation FD (Fair Disclosure). Accordingly, investors should monitor the Company Statements, Investor Information and Businesses portions of the Company's web site, in addition to following the Company's press releases, SEC filings, public conference calls, presentations and webcasts.
The information contained on, or that may be accessed through, the Company's web site is not incorporated by reference into, and is not a part of, this report.
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ITEM 1A. | RISK FACTORS |
You should carefully consider the following information, together with the information contained in AGL's other filings with the SEC. The risks and uncertainties discussed below are not the only ones the Company faces. However, these are the risks that the Company's management believes are material. The Company may face additional risks or uncertainties that are not presently known to the Company or that management currently deems immaterial, and such risks or uncertainties also may impair its business or results of operations. The risks discussed below could result in a significant or material adverse effect on the Company's financial condition, results of operations, liquidity or business prospects.
Risks Related to the Company's Expected Losses
Estimates of expected losses are subject to uncertainties and may not be adequate to cover potential paid claims.
The financial guaranties issued by the Company's insurance subsidiaries insure the credit performance of the guaranteed obligations over an extended period of time, in some cases over 30 years, and in most circumstances, the Company has no right to cancel such financial guaranties. As a result, the Company's estimate of ultimate losses on a policy is subject to significant uncertainty over the life of the insured transaction. Credit performance can be adversely affected by economic, fiscal and financial market variability over the long duration of most contracts. If the Company's actual losses exceed its current estimate, this may result in adverse effects on the Company's financial condition, results of operations, liquidity, business prospects, financial strength ratings and ability to raise additional capital.
In addition, if the Company is required to make claim payments, even if it is reimbursed in full over time and does not experience ultimate loss on a particular policy, such claim payments would reduce the Company's invested assets and result in reduced liquidity and net investment income. If the amount of claim payments is significant, the Company's ability to make other claim payments and its financial condition, financial strength ratings and business prospects could be adversely affected.
The Company has insured exposure of approximately $3.0 billion to infrastructure transactions with refinancing risk as to which the Company may need to make claim payments that it did not anticipate paying when the policies were issued. Although the Company may not experience ultimate loss on a particular transaction, the aggregate amount of the claim payments may be substantial and reimbursement may not occur for an extended time, if at all. These transactions generally involve long-term infrastructure projects that were financed by bonds that mature prior to the expiration of the project concession. The Company expected the cash flows from these projects to be sufficient to repay all of the debt over the life of the project concession, but also expected the debt to be refinanced in the market at or prior to its maturity. If the issuer is unable to refinance the debt due to market conditions, the Company may have to pay a claim when the debt matures, and then recover its payment from cash flows produced by the project in the future. The Company generally projects that in most scenarios it will be fully reimbursed for such payments. However, the recovery of the payments is uncertain and may take from 10 to 35 years, depending on the transaction and the performance of the underlying collateral. The Company estimates total claims for the two largest transactions with significant refinancing risk, assuming no refinancing, and based on certain performance assumptions could be $1.8 billion on a gross basis; such claims would be payable from 2017 through 2022.
The determination of expected loss is an inherently subjective process involving numerous estimates, assumptions and judgments by management, using both internal and external data sources with regard to frequency, severity of loss, economic projections, governmental actions, negotiations and other factors that affect credit performance. The Company does not use traditional actuarial approaches to determine its estimates of expected losses. Actual losses will ultimately depend on future events or transaction performance. As a result, the Company's current estimates of probable and estimable losses may not reflect the Company's future ultimate claims paid.
Certain sectors and large risks within the Company's insured portfolio have experienced credit deterioration in excess of the Company’s initial expectations, which has led or may lead to losses in excess of the Company’s initial expectations. The Company's expected loss models take into account current and expected future trends, which contemplate the impact of current and probable developments in the performance of the credit. These factors, which are integral elements of the Company's reserve estimation methodology, are updated on a quarterly basis based on current information. Because such information changes, sometimes materially, from quarter to quarter, the Company’s projection of losses may also change materially. Since the financial crisis, most of the development in the Company’s loss projections has been with respect to insured RMBS securities. While the Company's net par outstanding as of December 31, 2014 and December 31, 2013 for U.S. RMBS was still $9.4 billion and $13.7 billion, respectively, of which $5.6 billion and $7.7 billion, respectively, was rated BIG under the Company's rating methodology, and may still be a source of loss development, the Company believes the performance of this portfolio (and the related representations and warranties ("R&W") efforts) has stabilized. More recently, there has been credit deterioration and discussion between the issuers and creditors with respect to some of the Puerto Rico credits the Company
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insures. The Company had net par outstanding to Puerto Rico of $4.9 billion and $5.4 billion, respectively, as of December 31, 2014 and December 31, 2013, of which $4.7 billion and $5.2 billion, respectively, was rated BIG under the Company’s rating methodology. For a discussion of the Company's review of its Puerto Rico risks and RMBS transactions, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations-Consolidated Results of Operations-Losses in the Insured Portfolio."
Risks Related to the Company's Financial Strength and Financial Enhancement Ratings
A downgrade of the financial strength or financial enhancement ratings of any of the Company's insurance and reinsurance subsidiaries would adversely affect its business and prospects and, consequently, its results of operations and financial condition.
The financial strength and financial enhancement ratings assigned by S&P, Moody's and KBRA to AGL's insurance and reinsurance subsidiaries represent the rating agencies' opinions of the insurer's financial strength and ability to meet ongoing obligations to policyholders and cedants in accordance with the terms of the financial guaranties it has issued or the reinsurance agreements it has executed. The ratings also reflect qualitative factors, such as the rating agencies' opinion of an insurer's business strategy and franchise value, the anticipated future demand for its product, the composition of its insured portfolio, and its capital adequacy, profitability and financial flexibility. Issuers, investors, underwriters, ceding companies and others consider the Company's financial strength or financial enhancement ratings an important factor when deciding whether or not to utilize a financial guaranty or purchase reinsurance from one of the insurance or reinsurance subsidiaries. A downgrade by a rating agency of the financial strength or financial enhancement ratings of one or more of AGL's subsidiaries could impair the Company's financial condition, results of operation, liquidity, business prospects or other aspects of the Company's business.
The ratings assigned by the rating agencies that publish financial strength or financial enhancement ratings on AGL's insurance subsidiaries are subject to frequent review and may be lowered by a rating agency as a result of a number of factors, including, but not limited to, the rating agency's revised stress loss estimates for the Company's insurance portfolio, adverse developments in the Company's or the subsidiary's financial conditions or results of operations due to underwriting or investment losses or other factors, changes in the rating agency's outlook for the financial guaranty industry or in the markets in which the Company operates, or a revision in the rating agency's capital model or ratings methodology. Their reviews can occur at any time and without notice to the Company and could result in a decision to downgrade, revise or withdraw the financial strength or financial enhancement ratings of AGL's insurance and reinsurance subsidiaries.
Since 2008, each of S&P and Moody's has reviewed and downgraded the financial strength ratings of AGL's insurance and reinsurance subsidiaries, including AGC, AGM and AG Re. In addition, S&P and Moody's have from time to time changed the ratings outlook for certain of the Company's subsidiaries to "negative" from "stable" or have placed such ratings on watch for possible downgrade. For example, in March 2012, Moody's placed the ratings of AGL and its subsidiaries, including the financial strength ratings of AGL's insurance subsidiaries, on review for possible downgrade. Moody's did not complete its review until January 2013, when Moody's downgraded the financial strength ratings of AGM and AGC from Aa3 to A2 and A3, respectively, and that of AG Re from A1 to Baa1. In February 2014, Moody's affirmed the financial strength ratings and outlooks of AGM and AGC, and affirmed AG Re's financial strength rating, but changed AG Re's outlook to negative, citing its vulnerability to adverse developments within its insured portfolio. Then, in July 2014, Moody’s again affirmed the financial strength ratings of AGM and AGC, but changed AGC's outlook to negative, citing AGC's exposure to Puerto Rico credits, including those subject to the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the "Recovery Act"), the invalidation of which is currently being appealed by Puerto Rico in the U.S. Court of Appeals. In February 2015, Moody's published a credit opinion under its new financial guarantor ratings methodology maintaining its existing ratings and outlooks on AGM, AGC and AG Re. In the case of S&P, AGM, AGC and AG Re were assigned financial strength ratings of AA- (Stable Outlook) in November 2011, and then those ratings were upgraded to AA (Stable Outlook) in March 2014.
The Company believes that the uncertainty introduced by S&P and Moody's various actions and proposals have reduced the Company's new business opportunities and have also affected the value of the Company's product to issuers and investors. The insurance subsidiaries' financial strength ratings are an important competitive factor in the financial guaranty insurance and reinsurance markets. If the financial strength or financial enhancement ratings of one or more of the Company's insurance subsidiaries were reduced below current levels, the Company expects that would reduce the number of transactions that would benefit from the Company's insurance; consequently, a downgrade by rating agencies could harm the Company's new business production, results of operations and financial condition.
In addition, a downgrade may have a negative impact on the Company in respect of transactions that it has insured or reinsurance that it has assumed. For example, a downgrade of one of the Company's insurance subsidiaries may result in
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increased claims under financial guaranties such subsidiary has issued. Under variable rate demand obligations insured by AGM, further downgrades past rating levels specified in the transaction documents could result in the municipal obligor paying a higher rate of interest and in such obligations amortizing on a more accelerated basis than expected when the obligations originally were issued; if the municipal obligor is unable to make such interest or principal payments, AGM may receive a claim under its financial guaranty. Under interest rate swaps insured by AGM, further downgrades past specified rating levels could entitle the municipal obligor's swap counterparty to terminate the swap; if the municipal obligor owed a termination payment as a result and were unable to make such payment, AGM may receive a claim if its financial guaranty guaranteed such termination payment. For more information about increased claim payments the Company may potentially make, see "Ratings Impact on Financial Guaranty Business" in Note 7, Financial Guaranty Insurance Losses, of the Financial Statements and Supplementary Data. In certain other transactions, beneficiaries of financial guaranties issued by the Company's insurance subsidiaries may have the right to cancel the credit protection offered by the Company, which would result in the loss of future premium earnings and the reversal of any fair value gains recorded by the Company. In addition, a downgrade of AG Re or AGC could result in certain ceding companies recapturing business that they had ceded to these reinsurers. See "The downgrade of the financial strength ratings of AG Re or of AGC gives certain reinsurance counterparties the right to recapture ceded business, which would lead to a reduction in the Company's unearned premium reserve and related earnings on such reserve" below.
If AGC's financial strength or financial enhancement ratings were downgraded, the Company could be required to post additional collateral under certain of its credit derivative contracts. See "If AGC's financial strength or financial enhancement ratings were downgraded, the Company could be required to post collateral under certain of its credit derivative contracts, which could impair its liquidity and results of operations" below.
If AGM's financial strength or financial enhancement ratings were downgraded, AGM-insured GICs issued by the former AGMH subsidiaries that conducted AGMH's Financial Products Business (the "Financial Products Companies") may come due or may come due absent the provision of collateral by the GIC issuers. The Company relies on agreements pursuant to which Dexia has agreed to guarantee or lend certain amounts, or to post liquid collateral, in regards to AGMH's former financial products business. See "Risks Related to the Acquisition of AGMH—The Company has exposure to credit and liquidity risks from Dexia."
Furthermore, if the financial strength ratings of AGE or AGUK were downgraded, AGM or AGC may be required to contribute additional capital to their respective subsidiary pursuant to the terms of the support arrangements for such subsidiaries, including those described under "Material Contracts" in the "Regulation—United Kingdom" section of "Item 1. Business."
If AGC's financial strength or financial enhancement ratings were downgraded, the Company could be required to post collateral under certain of its credit derivative contracts, which could impair its liquidity and results of operations.
Within the Company’s insured CDS portfolio, the transaction documentation for approximately $6.1 billion in CDS gross par insured as of December 31, 2014 requires AGC and AGRO to post eligible collateral to secure its obligations to make payments under such contracts. Eligible collateral is generally cash or U.S. government or agency securities; eligible collateral other than cash is valued at a discount to the face amount.
• | For approximately $5.9 billion of such contracts, AGC has negotiated caps such that the posting requirement cannot exceed a certain fixed amount, regardless of the mark-to-market valuation of the exposure or the financial strength ratings of AGC. For such contracts, AGC need not post on a cash basis more than $665 million, although the value of the collateral posted may exceed such fixed amount depending on the advance rate agreed with the counterparty for the particular type of collateral posted. |
• | For the remaining approximately $242 million of such contracts, AGC or AGRO could be required from time to time to post additional collateral without such cap based on movements in the mark-to-market valuation of the underlying exposure. |
As of December 31, 2014, the Company was posting approximately $376 million to secure obligations under its CDS exposure, of which approximately $25 million related to such $242 million of notional. As of December 31, 2013, the Company posted approximately $677 million, of which approximately $62 million related to $347 million of notional where AGC or AGRO could be required to post additional collateral based on movements in the mark-to-market valuation of the underlying exposure. The obligation to post collateral could impair the Company's liquidity and results of operations.
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The downgrade of the financial strength ratings of AG Re or of AGC gives certain reinsurance counterparties the right to recapture ceded business, which would lead to a reduction in the Company's unearned premium reserve and related earnings on such reserve.
The downgrade of the financial strength ratings of AG Re or of AGC gives certain reinsurance counterparties the right to recapture ceded business, which would lead to a reduction in the Company's unearned premium reserve and related earnings on such reserve. With respect to a significant portion of the Company's in-force financial guaranty assumed business, based on AG Re's and AGC's current ratings and subject to the terms of each reinsurance agreement, the third party ceding company may have the right to recapture assumed business ceded to AG Re and/or AGC, and in connection therewith, to receive payment from the assuming reinsurer of an amount equal to the reinsurer’s statutory unearned premium (net of ceding commissions) and statutory loss reserves (if any) associated with that business, plus, in certain cases, an additional ceding commission. As of December 31, 2014, if each third party company ceding business to AG Re and/or AGC had a right to recapture such business, and chose to exercise such right, the aggregate amounts that AG Re and AGC could be required to pay to all such companies would be approximately $85 million and $45 million, respectively.
Actions taken by the rating agencies with respect to capital models and rating methodology of the Company's business or changes in capital charges or downgrades of transactions within its insured portfolio may adversely affect its ratings, business prospects, results of operations and financial condition.
The rating agencies from time to time have evaluated the Company's capital adequacy under a variety of scenarios and assumptions. The rating agencies do not always supply clear guidance on their approach to assessing the Company's capital adequacy and the Company may disagree with the rating agencies' approach and assumptions. For example, S&P assesses each individual credit (including potential new credits) insured by the Company based on a variety of factors, including the nature of the credit, the nature of the support or credit enhancement for the credit, its tenor, and its expected and actual performance. This assessment determines the amount of capital the Company is required to maintain against that credit to maintain its financial strength ratings under S&P's capital adequacy model. Sometimes the rating agencies consider the amount of additional capital that could be required for certain risks or sectors under certain stress scenarios based on their views of developments in the market, as each have done recently with respect to the Company's exposures to Puerto Rico. Factors influencing the rating agencies are beyond management's control and not always known to the Company. In the event of an actual or perceived deterioration in creditworthiness, or a change in a rating agency's capital model or rating methodology, that rating agency may require the Company to increase the amount of capital allocated to support the affected credits, regardless of whether losses actually occur, or against potential new business. Significant reductions in the rating agencies' assessments of credits in the Company's insured portfolio can produce significant increases in the amount of capital required for the Company to maintain its financial strength ratings under the rating agencies' capital adequacy models, which may require the Company to seek additional capital. The amount of such capital required may be substantial, and may not be available to the Company on favorable terms and conditions or at all. Accordingly, the Company cannot ensure that it will seek to, or be able to, raise additional capital. The failure to raise additional required capital could result in a downgrade of the Company's ratings and thus have an adverse impact on its business, results of operations and financial condition. See "Risks Related to the Company's Capital and Liquidity Requirements—The Company may require additional capital from time to time, including from soft capital and liquidity credit facilities, which may not be available or may be available only on unfavorable terms."
Since 2009, Moody's and S&P have downgraded a number of structured finance securities and public finance bonds, including obligations that the Company insures. Additional obligations in the Company's insured portfolio may be reviewed and downgraded in the future. Downgrades of the Company's insured credits will result in higher capital requirements for the Company under the relevant rating agency capital adequacy model. If the additional amount of capital required to support such exposures is significant, the Company may need to undertake certain actions in order to maintain its ratings, including, but not limited to, raising additional capital (which, if available, may not be available on terms and conditions that are favorable to the Company); curtailing new business; or paying to transfer a portion of its in-force business to generate rating agency capital. If the Company is unable to complete any of these capital initiatives, it could suffer ratings downgrades. These capital actions or ratings downgrades could adversely affect the Company's results of operations, financial condition, ability to write new business or competitive positioning.
Risks Related to the Financial, Credit and Financial Guaranty Markets
Improvement in the recent difficult conditions in the U.S. and world-wide financial markets has been gradual, and the Company's business, liquidity, financial condition and stock price may continue to be adversely affected.
The Company's loss reserves, profitability, financial position, insured portfolio, investment portfolio, cash flow, statutory capital and stock price could be materially affected by the U.S. and global financial markets. Upheavals in the
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financial markets affect economic activity and employment and therefore can affect the Company's business. The global economic outlook remains uncertain, including the overall growth rate of the U.S. economy, the fragile economic recovery in Europe and the impact of the gradual tightening of global monetary conditions on emerging markets. These and other risks could materially and negatively affect the Company’s ability to access the capital markets, the cost of the Company's debt, the demand for its products, the amount of losses incurred on transactions it guarantees, the value of its investment portfolio, its financial ratings and the price of its common shares.
Some of the state and local governments and entities that issue obligations the Company insures are experiencing significant budget deficits and revenue shortfalls that could result in increased credit losses or impairments and capital charges on those obligations.
State and local governments that issue some of the obligations the Company insures have experienced significant budget deficits and revenue collection shortfalls that required them to significantly raise taxes and/or cut spending in order to satisfy their obligations. While the U.S. government has provided some financial support and although overall state revenues have increased in recent years, significant budgetary pressures remain, especially at the local government level and in relation to retirement obligations. Certain local governments, including ones that have issued obligations insured by the Company, have sought protection from creditors under chapter 9 of the U.S. Bankruptcy Code as a means of restructuring their outstanding debt. In some recent instances where local governments were seeking to restructure their outstanding debt, and partially in response to concerns that materially reducing pension payments would lead to employee flight and, therefore, an inadequate level of local government services, pension and other obligations owed to workers were treated more favorably than senior bond debt owed to the capital markets. If the issuers of the obligations in the Company's public finance portfolio do not have sufficient funds to cover their expenses and are unable or unwilling to raise taxes, decrease spending or receive federal assistance, the Company may experience increased levels of losses or impairments on its public finance obligations, which could materially and adversely affect its business, financial condition and results of operations. If such issuers succeed in restructuring pension and other obligations owed to workers so that they are treated more favorably than obligations insured by the Company, such losses or impairments could be greater than the Company otherwise anticipated when the insurance was written.
The Company's risk of loss on and capital charges for municipal credits could also be exacerbated by rating agency downgrades of municipal credit ratings. A downgraded municipal issuer may be unable to refinance maturing obligations or issue new debt, which could reduce the municipality's ability to service its debt. Downgrades could also affect the interest rate that the municipality must pay on its variable rate debt or for new debt issuance. Municipal credit downgrades, as with other downgrades, result in an increase in the capital charges the rating agencies assess when evaluating the Company's capital adequacy in their rating models. Significant municipal downgrades could result in higher capital requirements for the Company in order to maintain its financial strength ratings.
The Company insures general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations. The Commonwealth faces a challenging economic environment and, in recent years, has experienced significant general fund budget deficits, which it has attempted to address by issuing debt. In June 2014, the Puerto Rico legislature passed the Recovery Act in order to provide a legislative framework for certain public corporations experiencing severe financial stress to restructure their debt. Following the enactment of the Recovery Act, S&P, Moody’s and Fitch Ratings lowered the credit rating of the Commonwealth’s bonds and the ratings on certain of Puerto Rico’s public corporations. On February 6, 2015, the U.S. District Court for the District of Puerto Rico ruled that the Recovery Act is preempted by the U.S. Bankruptcy Code and is therefore void; on February 19, 2015, the Commonwealth appealed the ruling to the U.S. Court of Appeals for the First Circuit. After the U.S. District Court ruling, S&P and Moody's again lowered the credit rating of the Commonwealth's bonds and the ratings on certain of Puerto Rico's public corporations. The Commonwealth has disclosed its liquidity has been adversely affected by rating agency downgrades and by the limited market access for its debt, and also noted it has relied on short-term financings and interim loans from the Government Development Bank for Puerto Rico ("GDB") and other private lenders, which reliance has constrained its liquidity and increased its near-term refinancing risk. The Company has an aggregate $4.9 billion net par exposure to the Commonwealth and various obligations of its related authorities and public corporations, and if the Company were required to make claim payments on such insured exposures, such payments could have a negative effect on the Company's liquidity and results of operations.
In addition, obligations supported by specified revenue streams, such as revenue bonds issued by toll road authorities, municipal utilities or airport authorities, may be adversely affected by revenue declines resulting from reduced demand, changing demographics or other factors associated with an economy in which unemployment remains high, housing prices have not yet stabilized and growth is slow. These obligations, which may not necessarily benefit from financial support from other tax revenues or governmental authorities, may also experience increased losses if the revenue streams are insufficient to pay scheduled interest and principal payments.
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Changes in interest rate levels and credit spreads could adversely affect demand for financial guaranty insurance as well as the Company's financial condition.
Demand for financial guaranty insurance generally fluctuates with changes in market credit spreads. Credit spreads, which are based on the difference between interest rates on high-quality or "risk free" securities versus those on lower-rated or uninsured securities, fluctuate due to a number of factors and are sensitive to the absolute level of interest rates, current credit experience and investors' risk appetite. Within the last five years, interest rates in the U.S. have been at historically low levels. In 2014, 30-year municipal interest rates fell approximately 133 basis points from their level at year-end 2013, a year in which rates were already low by historical standards. When interest rates are low, or when the market is relatively less risk averse, the credit spread between high-quality or insured obligations versus lower- rated or uninsured obligations typically narrows. As a result, financial guaranty insurance typically provides lower interest cost savings to issuers than it would during periods of relatively wider credit spreads. When issuers are less likely to use financial guaranties on their new issues when credit spreads are narrow, this results in decreased demand or premiums obtainable for financial guaranty insurance, and a resulting reduction in the Company's results of operations.
Conversely, in a deteriorating credit environment, credit spreads increase and become "wide", which increases the interest cost savings that financial guaranty insurance may provide and can result in increased demand for financial guaranties by issuers. However, if the weakening credit environment is associated with economic deterioration, the Company's insured portfolio could generate claims and loss payments in excess of normal or historical expectations. In addition, increases in market interest rate levels could reduce new capital markets issuances and, correspondingly, a decreased volume of insured transactions.
Competition in the Company's industry may adversely affect its revenues.
As described in greater detail under "Competition" in "Item 1. Business," the Company can face competition, either in the form of current or new providers of credit enhancement or in terms of alternative structures, including uninsured offerings, or pricing competition. Increased competition could have an adverse effect on the Company's insurance business.
The Company's financial position, results of operations and cash flows may be adversely affected by fluctuations in foreign exchange rates.
The Company's reporting currency is the U.S. dollar. The functional currencies of AGL's insurance and reinsurance subsidiaries are the U.S. dollar and U.K. sterling. Exchange rate fluctuations relative to the functional currencies may materially impact the Company's financial position, results of operations and cash flows. The Company's non-U.S. subsidiaries maintain both assets and liabilities in currencies different than their functional currency, which exposes the Company to changes in currency exchange rates. In addition, locally-required capital levels are invested in local currencies in order to satisfy regulatory requirements and to support local insurance operations regardless of currency fluctuations.
The principal currencies creating foreign exchange risk are the British pound sterling and the European Union euro. The Company cannot accurately predict the nature or extent of future exchange rate variability between these currencies or relative to the U.S. dollar. Foreign exchange rates are sensitive to factors beyond the Company's control. The Company does not engage in active management, or hedging, of its foreign exchange rate risk. Therefore, fluctuation in exchange rates between these currencies and the U.S. dollar could adversely impact the Company's financial position, results of operations and cash flows.
The Company's international operations expose it to less predictable credit and legal risks.
The Company pursues new business opportunities in international markets. The underwriting of obligations of an issuer in a foreign country involves the same process as that for a domestic issuer, but additional risks must be addressed, such as the evaluation of foreign currency exchange rates, foreign business and legal issues, and the economic and political environment of the foreign country or countries in which an issuer does business. Changes in such factors could impede the Company's ability to insure, or increase the risk of loss from insuring, obligations in the countries in which it currently does business and limit its ability to pursue business opportunities in other countries.
The Company's investment portfolio may be adversely affected by credit, interest rate and other market changes.
The Company's operating results are affected, in part, by the performance of its investment portfolio which consists primarily of fixed-income securities and short-term investments. As of December 31, 2014, the fixed-maturity securities and short-term investments had a fair value of approximately $11.3 billion. Credit losses and changes in interest rates could have an
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adverse effect on its shareholders' equity and net income. Credit losses result in realized losses on the Company's investment portfolio, which reduce net income and shareholders' equity. Changes in interest rates can affect both shareholders' equity and investment income. For example, if interest rates decline, funds reinvested will earn less than expected, reducing the Company's future investment income compared to the amount it would earn if interest rates had not declined. However, the value of the Company's fixed-rate investments would generally increase if interest rates decreased, resulting in an unrealized gain on investments included in shareholders' equity. Conversely, if interest rates increase, the value of the investment portfolio will be reduced, resulting in unrealized losses that the Company is required to include in shareholders' equity as a change in accumulated other comprehensive income. Accordingly, interest rate increases could reduce the Company's shareholders' equity.
Interest rates are highly sensitive to many factors, including monetary policies, domestic and international economic and political conditions and other factors beyond the Company's control. The Company does not engage in active management, or hedging, of interest rate risk, and may not be able to mitigate interest rate sensitivity effectively.
The market value of the investment portfolio also may be adversely affected by general developments in the capital markets, including decreased market liquidity for investment assets, market perception of increased credit risk with respect to the types of securities held in the portfolio, downgrades of credit ratings of issuers of investment assets and/or foreign exchange movements which impact investment assets. In addition, the Company invests in securities insured by other financial guarantors, the market value of which may be affected by the rating instability of the relevant financial guarantor.
Risks Related to the Company's Capital and Liquidity Requirements
The Company may require additional capital from time to time, including from soft capital and liquidity credit facilities, which may not be available or may be available only on unfavorable terms.
The Company's capital requirements depend on many factors, primarily related to its in-force book of business and rating agency capital requirements. The Company needs liquid assets to make claim payments on its insured portfolio and to write new business. For example, as discussed in the Risk Factor captioned "Estimates of expected losses are subject to uncertainties and may not be adequate to cover potential paid claims" under Risks Related to the Company's Expected Losses, the Company has substantial exposure to infrastructure transactions with refinancing risk as to which the Company may need to make large claim payments that it did not anticipate paying when the policies were issued. Failure to raise additional capital as needed may result in the Company being unable to write new business and may result in the ratings of the Company and its subsidiaries being downgraded by one or more ratings agency. The Company's access to external sources of financing, as well as the cost of such financing, is dependent on various factors, including the market supply of such financing, the Company's long-term debt ratings and insurance financial strength ratings and the perceptions of its financial strength and the financial strength of its insurance subsidiaries. The Company's debt ratings are in turn influenced by numerous factors, such as financial leverage, balance sheet strength, capital structure and earnings trends. If the Company's need for capital arises because of significant losses, the occurrence of these losses may make it more difficult for the Company to raise the necessary capital.
Future capital raises for equity or equity-linked securities could also result in dilution to the Company's shareholders. In addition, some securities that the Company could issue, such as preferred stock or securities issued by the Company's operating subsidiaries, may have rights, preferences and privileges that are senior to those of its common shares.
Financial guaranty insurers and reinsurers typically rely on providers of lines of credit, credit swap facilities and similar capital support mechanisms (often referred to as "soft capital") to supplement their existing capital base, or "hard capital." The ratings of soft capital providers directly affect the level of capital credit which the rating agencies give the Company when evaluating its financial strength. The Company currently maintains soft capital facilities with providers having ratings adequate to provide the Company's desired capital credit. For example, effective January 1, 2014, AGC, AGM and MAC entered into a $450 million aggregate excess of loss reinsurance facility that covers certain U.S. public finance credits insured or reinsured by those companies. However, no assurance can be given that the Company will be able to renew any existing soft capital facilities or that one or more of the rating agencies will not downgrade or withdraw the applicable ratings of such providers in the future. In addition, the Company may not be able to replace a downgraded soft capital provider with an acceptable replacement provider for a variety of reasons, including if an acceptable replacement provider is willing to provide the Company with soft capital commitments or if any adequately-rated institutions are actively providing soft capital facilities. Furthermore, the rating agencies may in the future change their methodology and no longer give credit for soft capital, which may necessitate the Company having to raise additional capital in order to maintain its ratings.
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An increase in AGL's subsidiaries' leverage ratio may prevent them from writing new insurance.
Insurance regulatory authorities impose capital requirements on AGL's insurance subsidiaries. These capital requirements, which include leverage ratios and surplus requirements, may limit the amount of insurance that the subsidiaries may write. The insurance subsidiaries have several alternatives available to control their leverage ratios, including obtaining capital contributions from the Company, purchasing reinsurance or entering into other loss mitigation agreements, or reducing the amount of new business written. However, a material reduction in the statutory capital and surplus of a subsidiary, whether resulting from underwriting or investment losses, a change in regulatory capital requirements or otherwise, or a disproportionate increase in the amount of risk in force, could increase a subsidiary's leverage ratio. This in turn could require that subsidiary to obtain reinsurance for existing business (which may not be available, or may be available on terms that the Company considers unfavorable), or add to its capital base to maintain its financial strength ratings. Failure to maintain regulatory capital levels could limit that subsidiary's ability to write new business.
The Company's holding companies' ability to meet its obligations may be constrained.
Each of AGL, AGUS and AGMH is a holding company and, as such, has no direct operations of its own. None of the holding companies expects to have any significant operations or assets other than its ownership of the shares of its subsidiaries.
The insurance company subsidiaries’ ability to pay dividends and make other payments depends, among other things, upon their financial condition, results of operations, cash requirements, and compliance with rating agency requirements, and is also subject to restrictions contained in the insurance laws and related regulations of their states of domicile. Restrictions applicable to AGC and AGM, and to AG Re and AGRO, are described under the "Regulation—United States—State Dividend Limitations" and "Regulation—Bermuda—Restrictions on Dividends and Distributions" sections of “Item 1. Business.” Such dividends and permitted payments are expected to be the primary source of funds for the holding companies to meet ongoing cash requirements, including operating expenses, any future debt service payments and other expenses, and to pay dividends to their respective shareholders. Accordingly, if the insurance subsidiaries cannot pay sufficient dividends or make other permitted payments at the times or in the amounts that are required, that would have an adverse effect on the ability of AGL, AGUS and AGMH to satisfy their ongoing cash requirements and on their ability to pay dividends to shareholders.
If AGRO were to pay dividends to its U.S. holding company parent and that U.S. holding company were to pay dividends to its Bermudian parent AG Re, such dividends would be subject to U.S. withholding tax at a rate of 30%.
The ability of AGL and its subsidiaries to meet their liquidity needs may be limited.
Each of AGL, AGUS and AGMH requires liquidity, either in the form of cash or in the ability to easily sell investment assets for cash, in order to meet its payment obligations, including, without limitation, its operating expenses, interest on debt and dividends on common shares, and to make capital investments in operating subsidiaries. The Company's operating subsidiaries require substantial liquidity in order to meet their respective payment and/or collateral posting obligations, including under financial guaranty insurance policies, CDS contracts or reinsurance agreements. They also require liquidity to pay operating expenses, reinsurance premiums, dividends to AGUS or AGMH for debt service and dividends to the Company, as well as, where appropriate, to make capital investments in their own subsidiaries. The Company cannot give any assurance that the liquidity of AGL and its subsidiaries will not be adversely affected by adverse market conditions, changes in insurance regulatory law or changes in general economic conditions.
AGL anticipates that its liquidity needs will be met by the ability of its operating subsidiaries to pay dividends or to make other payments; external financings; investment income from its invested assets; and current cash and short-term investments. The Company expects that its subsidiaries' need for liquidity will be met by the operating cash flows of such subsidiaries; external financings; investment income from their invested assets; and proceeds derived from the sale of its investment portfolio, a significant portion of which is in the form of cash or short-term investments. All of these sources of liquidity are subject to market, regulatory or other factors that may impact the Company's liquidity position at any time. As discussed above, AGL's insurance subsidiaries are subject to regulatory and rating agency restrictions limiting their ability to declare and to pay dividends and make other payments to AGL. As further noted above, external financing may or may not be available to AGL or its subsidiaries in the future on satisfactory terms.
In addition, investment income at AGL and its subsidiaries may fluctuate based on interest rates, defaults by the issuers of the securities AGL or its subsidiaries hold in their respective investment portfolios, or other factors that the Company does not control. Finally, the value of the Company's investments may be adversely affected by changes in interest rates, credit risk and capital market conditions and therefore may adversely affect the Company's potential ability to sell investments quickly and the price which the Company might receive for those investments.
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Risks Related to the Acquisition of AGMH
The Company has exposure to credit and liquidity risks from Dexia.
Dexia and the Company have entered into a number of agreements intended to protect the Company from having to pay claims on AGMH's former Financial Products Business, which the Company did not acquire. Dexia has agreed to guarantee certain amounts, lend certain amounts or post liquid collateral for or in respect of AGMH's former Financial Products Business. Dexia SA and Dexia Crédit Local S.A. ("DCL"), jointly and severally, have also agreed to indemnify the Company for losses associated with AGMH's former Financial Products Business, including the ongoing Department of Justice investigations of such business. Furthermore, DCL, acting through its New York Branch, is providing a liquidity facility in order to make loans to AGM to finance the payment of claims under certain financial guaranty insurance policies issued by AGM or its affiliate that relate to the equity portion of leveraged lease transactions insured by AGM. The equity portion of the leveraged lease transactions is part of AGMH's financial guaranty business, which the Company did acquire. The amount of such claims could be large and are generally payable within a short time after AGM receives them. For a description of the agreements entered into with Dexia and a further discussion of the risks that these agreements are intended to protect against, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Liquidity Arrangements with respect to AGMH's former Financial Products Business."
Despite the execution of such documentation, the Company remains subject to the risk that Dexia may not make payments or securities available (a) on a timely basis, which is referred to as "liquidity risk," or (b) at all, which is referred to as "credit risk," because of the risk of default. Even if Dexia has sufficient assets to pay, lend or post as collateral all amounts when due, concerns regarding Dexia's financial condition or willingness to comply with its obligations could cause one or more rating agencies to view negatively the ability or willingness of Dexia to perform under its various agreements and could negatively affect the Company's ratings.
AGMH and its subsidiaries could be subject to non-monetary consequences arising out of litigation associated with AGMH's former financial products business, which the Company did not acquire.
As noted under "Item 3. Legal Proceedings—Proceedings Related to AGMH's Former Financial Products Business," in November 2006, AGMH received a subpoena from the Antitrust Division of the Department of Justice issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives. Although the subpoena relates to AGMH's former Financial Products Business, which the Company did not acquire, it was issued to AGMH, which the Company did acquire. Furthermore, while Dexia SA and DCL, jointly and severally, have agreed to indemnify the Company against liability arising out of these proceedings, such indemnification might not be sufficient to fully hold the Company harmless against any injunctive relief or civil or criminal sanction that is imposed against AGMH or its subsidiaries.
Risks Related to the Company's Business
The Company's financial guaranty products may subject it to significant risks from individual or correlated credits.
The Company is exposed to the risk that issuers of debt that it insures or other counterparties may default in their financial obligations, whether as a result of insolvency, lack of liquidity, operational failure or other reasons. Similarly, the Company could be exposed to corporate credit risk if a corporation's securities are contained in a portfolio of collateralized debt obligations ("CDOs") it insures, or if the corporation or financial institution is the originator or servicer of loans, mortgages or other assets backing structured securities that the Company has insured.
In addition, because the Company insures or reinsures municipal bonds, it can have significant exposures to single municipal risks (i.e., the Commonwealth of Puerto Rico). While the Company's risk of a complete loss, where it would have to pay the entire principal amount of an issue of bonds and interest thereon with no recovery, is generally lower than for corporate credits as most municipal bonds are backed by tax or other revenues, there can be no assurance that a single default by a municipality would not have a material adverse effect on its results of operations or financial condition.
The Company's ultimate exposure to a single name may exceed its underwriting guidelines, and an event with respect to a single name may cause a significant loss. The Company seeks to reduce this risk by managing exposure to large single risks, as well as concentrations of correlated risks, through tracking its aggregate exposure to single names in its various lines of business, establishing underwriting criteria to manage risk aggregations. It has also in the past obtained third party reinsurance for such exposure. The Company may insure and has insured individual public finance and asset-backed risks well in excess of $1 billion. Should the Company's risk assessments prove inaccurate and should the applicable limits prove
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inadequate, the Company could be exposed to larger than anticipated losses, and could be required by the rating agencies to hold additional capital against insured exposures whether or not downgraded by the rating agencies.
The Company is exposed to correlation risk across the various assets the Company insures. During periods of strong macroeconomic performance, stress in an individual transaction generally occurs in a single asset class or for idiosyncratic reasons. During a broad economic downturn, a wider range of the Company's insured portfolio could be exposed to stress at the same time. This stress may manifest itself in ratings downgrades, which may require more capital, or in actual losses. In addition, while the Company has experienced catastrophic events in the past without material loss, unexpected catastrophic events may have a material adverse effect upon the Company's insured portfolio and/or its investment portfolios.
Some of the Company's direct financial guaranty products may be riskier than traditional financial guaranty insurance.
As of December 31, 2014 and 2013, 9% and 13%, respectively, of the Company's financial guaranty direct exposures were executed as credit derivatives. Traditional financial guaranty insurance provides an unconditional and irrevocable guaranty that protects the holder of a municipal finance or structured finance obligation against non-payment of principal and interest, while credit derivatives provide protection from the occurrence of specified credit events, including non-payment of principal and interest. In general, the Company structures credit derivative transactions such that circumstances giving rise to its obligation to make payments are similar to that for financial guaranty policies and generally occur when issuers fail to make payments on the underlying reference obligations. The tenor of credit derivatives exposures, like exposure under financial guaranty insurance policies, is also generally for as long as the reference obligation remains outstanding.
Nonetheless, credit derivative transactions are governed by International Swaps and Derivatives Association, Inc. ("ISDA") documentation and operate differently from financial guaranty insurance policies. For example, the Company's control rights with respect to a reference obligation under a credit derivative may be more limited than when it issues a financial guaranty insurance policy on a direct primary basis. In addition, a credit derivative may be terminated for a breach of the ISDA documentation or other specific events, unlike financial guaranty insurance policies. In addition, under a limited number of credit derivative contracts, the Company may be required to post eligible securities as collateral, generally cash or U.S. government or agency securities, under specified circumstances. The need to post collateral under many of these transactions is subject to caps that the Company has negotiated with its counterparties, but there are some transactions as to which the Company could be required to post collateral without such a cap based on movements in the mark-to-market valuation of the underlying exposure in excess of contractual thresholds. See "Risks Related to the Company's Financial Strength and Financial Enhancement Ratings—If AGC's financial strength or financial enhancement ratings were downgraded, the Company could be required to post collateral under certain of its credit derivative contracts, which could impair its liquidity and results of operations."
Further downgrades of one or more of the Company's reinsurers could reduce the Company's capital adequacy and return on equity. The impairment of other financial institutions also could adversely affect the Company.
At December 31, 2014, the Company had ceded approximately 5% of its principal amount of insurance outstanding to third party reinsurers. In evaluating the credits insured by the Company, securities rating agencies allow capital charge "credit" for reinsurance based on the reinsurers' ratings. In recent years, a number of the Company's reinsurers were downgraded by one or more rating agencies, resulting in decreases in the credit allowed for reinsurance and in the financial benefits of using reinsurance under existing rating agency capital adequacy models. Many of the Company's reinsurers have already been downgraded to single-A or below by one or more rating agencies. The Company could be required to raise additional capital to replace the lost reinsurance credit in order to satisfy rating agency and regulatory capital adequacy and single risk requirements. The rating agencies' reduction in credit for reinsurance could also ultimately reduce the Company's return on equity to the extent that ceding commissions paid to the Company by the reinsurers were not adequately increased to compensate for the effect of any additional capital required. In addition, downgraded reinsurers may default on amounts due to the Company and such reinsurer obligations may not be adequately collateralized, resulting in additional losses to the Company and a reduction in its shareholders' equity and net income.
The Company also has exposure to counterparties in various industries, including banks, hedge funds and other investment vehicles in its insured transactions. Many of these transactions expose the Company to credit risk in the event its counterparty fails to perform its obligations.
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The Company is dependent on key executives and the loss of any of these executives, or its inability to retain other key personnel, could adversely affect its business.
The Company's success substantially depends upon its ability to attract and retain qualified employees and upon the ability of its senior management and other key employees to implement its business strategy. The Company believes there are only a limited number of available qualified executives in the business lines in which the Company competes. The Company relies substantially upon the services of Dominic J. Frederico, President and Chief Executive Officer, and other executives. Although the Company has designed its executive compensation with the goal of retaining and incentivizing its executive officers, the Company may not be successful in retaining their services. The loss of the services of any of these individuals or other key members of the Company's management team could adversely affect the implementation of its business strategy.
The Company is dependent on its information technology and that of certain third parties, and a cyber-attack, security breach or failure in such systems could adversely affect the Company’s business.
The Company relies upon information technology and systems, including technology and systems provided by or interfacing with those of third parties, to support a variety of its business processes and activities. In addition, the Company has collected and stored confidential information including, in connection with certain loss mitigation and due diligence activities related to its structured finance business, personally identifiable information. While the Company does not believe that the financial guaranty industry is as inherently prone to cyber-attacks as industries relating to, for example, payment card processing, banking, critical infrastructure or defense contracting, the Company’s data systems and those of third parties on which it relies are still vulnerable to security breaches due to cyber-attacks, viruses, malware, hackers and other external hazards, as well as inadvertent errors, equipment and system failures, and employee misconduct. Problems in or security breaches of these systems could, for example, result in lost business, reputational harm, the disclosure or misuse of confidential or proprietary information, incorrect reporting, inaccurate loss projections, legal costs and regulatory penalties.
The Company’s business operations rely on the continuous availability of its computer systems as well as those of certain third parties. In addition to disruptions caused by cyber-attacks or other data breaches, such systems may be adversely affected by natural and man-made catastrophes. The Company’s failure to maintain business continuity in the wake of such events, particularly if there were an interruption for an extended period, could prevent the timely completion of critical processes across its operations, including, for example, claims processing, treasury and investment operations and payroll. These failures could result in additional costs, loss of business, fines and litigation.
Risks Related to GAAP and Applicable Law
Changes in the fair value of the Company's insured credit derivatives portfolio may subject net income to volatility.
The Company is required to mark-to-market certain derivatives that it insures, including CDS that are considered derivatives under GAAP. Although there is no cash flow effect from this "marking-to-market," net changes in the fair value of the derivative are reported in the Company's consolidated statements of operations and therefore affect its reported earnings. As a result of such treatment, and given the large principal balance of the Company's CDS portfolio, small changes in the market pricing for insurance of CDS will generally result in the Company recognizing material gains or losses, with material market price increases generally resulting in large reported losses under GAAP. Accordingly, the Company's GAAP earnings will be more volatile than would be suggested by the actual performance of its business operations and insured portfolio.
The fair value of a credit derivative will be affected by any event causing changes in the credit spread (i.e., the difference in interest rates between comparable securities having different credit risk) on an underlying security referenced in the credit derivative. Common events that may cause credit spreads on an underlying municipal or corporate security referenced in a credit derivative to fluctuate include changes in the state of national or regional economic conditions, industry cyclicality, changes to a company's competitive position within an industry, management changes, changes in the ratings of the underlying security, movements in interest rates, default or failure to pay interest, or any other factor leading investors to revise expectations about the issuer's ability to pay principal and interest on its debt obligations. Similarly, common events that may cause credit spreads on an underlying structured security referenced in a credit derivative to fluctuate may include the occurrence and severity of collateral defaults, changes in demographic trends and their impact on the levels of credit enhancement, rating changes, changes in interest rates or prepayment speeds, or any other factor leading investors to revise expectations about the risk of the collateral or the ability of the servicer to collect payments on the underlying assets sufficient to pay principal and interest. The fair value of credit derivative contracts also reflects the change in the Company's own credit cost, based on the price to purchase credit protection on AGC and AGM. For discussion of the Company's fair value methodology for credit derivatives, see Note 8, Fair Value Measurement, of the Financial Statements and Supplementary Data.
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If a credit derivative is held to maturity and no credit loss is incurred, any unrealized gains or losses previously reported would be offset as the transactions reach maturity. Due to the complexity of fair value accounting and the application of GAAP requirements, future amendments or interpretations of relevant accounting standards may cause the Company to modify its accounting methodology in a manner which may have an adverse impact on its financial results.
Change in industry and other accounting practices could impair the Company's reported financial results and impede its ability to do business.
Changes in or the issuance of new accounting standards, as well as any changes in the interpretation of current accounting guidance, may have an adverse effect on the Company's reported financial results, including future revenues, and may influence the types and/or volume of business that management may choose to pursue.
Changes in or inability to comply with applicable law could adversely affect the Company's ability to do business.
The Company’s businesses are subject to direct and indirect regulation under state insurance laws, federal securities, commodities and tax laws affecting public finance and asset backed obligations, and federal regulation of derivatives, as well as applicable laws in the other countries in which the Company operates. Future legislative, regulatory, judicial or other legal changes in the jurisdictions in which the Company does business may adversely affect its ability to pursue its current mix of business, thereby materially impacting its financial results by, among other things, limiting the types of risks it may insure, lowering applicable single or aggregate risk limits, increasing required reserves or capital, increasing the level of supervision or regulation to which the Company’s operations may be subject, imposing restrictions that make the Company’s products less attractive to potential buyers, lowering the profitability of the Company’s business activities, requiring the Company to change certain of its business practices and exposing it to additional costs (including increased compliance costs).
In particular, regulations under the Dodd-Frank Act impose requirements on activities that AGL's subsidiaries may engage in that involve “swaps,” as defined under that Act. Although final product rules published by the CFTC and SEC in August 2012 established an insurance safe-harbor that provides that AGM’s and AGC's financial guaranty insurance policies are not generally deemed swaps under the Dodd-Frank Act and are therefore not subject to regulation under the Act as swaps, regulations under the Act could require certain of AGL's subsidiaries to register with the CFTC or the SEC as a “major swap participant” (“MSP”) or “major security-based swap participant” (“MSBSP”), respectively, as a result of either the legacy financial guaranty insurance policies and derivatives portfolios or new activities. MSPs or MSBSPs would need to satisfy the regulatory margin and capital requirements of the applicable agency and would be subject to additional compliance requirements.
The Company has analyzed the exposures created by its legacy financial guaranty insurance policies and derivatives portfolio and determined its subsidiaries do not need to register as an MSP with the CFTC at this time, based on the historical sizes of those exposures. However, in the event such swap exposure exceeds the triggers, then one or more of AGL's subsidiaries may be required to register as an MSP with the CFTC. The SEC has not adopted final rules for MSBSP registration yet, but when such rules are issued, one or more of AGL's subsidiaries may be required to register as an MSBSP with the SEC.
In addition, certain of AGL's subsidiaries may need to post margin with respect to either future or legacy derivative transactions when rules relating to margin take effect. While the relevant regulators (including U.S. bank regulators, the CFTC and the SEC) have indicated that they do not intend to require margin for legacy derivative transactions, when these regulators adopt margin requirements, it is possible that they will take the position that amendments to existing swaps will cause the amended swaps to be treated as new swaps for purposes of these margin rules and certain other new regulatory requirements. Such an expansion of the margin and other regulatory requirements to amendments of existing swaps may impede the Company's ability to amend insured derivative transactions in connection with loss mitigation efforts or municipal refunding transactions. The magnitude of capital and/or margin requirements could be substantial and, as discussed in “Risks Related to the Company's Capital and Liquidity Requirements — The Company may require additional capital from time to time, including from soft capital and liquidity credit facilities, which may not be available or may be available only on unfavorable terms,” there can be no assurance that the Company will be able to obtain, or obtain on favorable terms, such additional capital as may be required by the Dodd-Frank Act.
The foregoing requirements, as well as others that could be applied to the Company as a result of the legislation, could limit the Company’s ability to conduct certain lines of business and/or subject the Company to enhanced business conduct standards and/or otherwise adversely affect its future results of operations. Because many provisions of the Dodd-Frank Act are being implemented through agency rulemaking processes, a number of which have not been completed, the Company's assessment of the legislation’s impact on its business remains uncertain and is subject to change.
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In addition, the decline in the financial strength of many financial guaranty insurers has caused government officials to examine the suitability of some of the complex securities guaranteed by financial guaranty insurers. For example, NYDFS had announced that it would develop new rules and regulations for the financial guaranty industry. On September 22, 2008, the NYDFS issued Circular Letter No. 19 (2008) (the “Circular Letter”), which established best practices guidelines for financial guaranty insurers effective January 1, 2009. Although the Company is not aware of any current efforts by the NYDFS to propose legislation to formalize these guidelines, any such legislation may limit the amount of new structured finance business that AGC may write.
Furthermore, if the Company fails to comply with applicable insurance laws and regulations it could be exposed to fines, the loss of insurance licenses, limitations on the right to originate new business and restrictions on its ability to pay dividends, all of which could have an adverse impact on its business results and prospects. If an insurance company’s surplus declines below minimum required levels, the insurance regulator could impose additional restrictions on the insurer or initiate insolvency proceedings. AGC and AGM may increase surplus by various means, including obtaining capital contributions from the Company, purchasing reinsurance or entering into other loss mitigation arrangements, reducing the amount of new business written or obtaining regulatory approval to release contingency reserves. From time to time, AGM and AGC have obtained approval from their regulators to release contingency reserves based on losses and, in the case of AGM, also based on the expiration of its insured exposure.
From time to time, legislators have called for changes to the Internal Revenue Code in order to limit or eliminate the Federal income tax exclusion for municipal bond interest. Such a change would increase the cost of borrowing for state and local governments, and as a result, could cause a decrease in infrastructure spending by states and municipalities. Municipalities may issue a lower volume of bonds, and in particular may be less likely to refund existing debt, in which case, the amount of bonds that can benefit from insurance might also be reduced.
AGL's ability to pay dividends may be constrained by certain insurance regulatory requirements and restrictions.
AGL is subject to Bermuda regulatory requirements that affect its ability to pay dividends on common shares and to make other payments. Under the Bermuda Companies Act 1981, as amended, AGL may declare or pay a dividend only if it has reasonable grounds for believing that it is, and after the payment would be, able to pay its liabilities as they become due, and if the realizable value of its assets would not be less than its liabilities. While AGL currently intends to pay dividends on its common shares, investors who require dividend income should carefully consider these risks before investing in AGL. In addition, if, pursuant to the insurance laws and related regulations of Bermuda, Maryland and New York, AGL's insurance subsidiaries cannot pay sufficient dividends to AGL at the times or in the amounts that it requires, it would have an adverse effect on AGL's ability to pay dividends to shareholders. See "Risks Related to the Company's Capital and Liquidity Requirements—The ability of AGL and its subsidiaries to meet their liquidity needs may be limited."
Applicable insurance laws may make it difficult to effect a change of control of AGL.
Before a person can acquire control of a U.S. or U.K. insurance company, prior written approval must be obtained from the insurance commissioner of the state or country where the insurer is domiciled. Because a person acquiring 10% or more of AGL's common shares would indirectly control the same percentage of the stock of its U.S. insurance company subsidiaries, the insurance change of control laws of Maryland, New York and the U.K. would likely apply to such a transaction. These laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of AGL, including through transactions, and in particular unsolicited transactions, that some or all of its shareholders might consider to be desirable. While AGL's Bye-Laws limit the voting power of any shareholder to less than 10%, we cannot assure you that the applicable regulatory body would agree that a shareholder who owned 10% or more of its common shares did not control the applicable insurance company subsidiary, notwithstanding the limitation on the voting power of such shares.
Risks Related to Taxation
Changes in U.S. tax laws could reduce the demand or profitability of financial guaranty insurance, or negatively impact the Company's investment portfolio.
Any material change in the U.S. tax treatment of municipal securities, the imposition of a national sales tax or a flat tax in lieu of the current federal income tax structure in the U.S., or changes in the treatment of dividends, could adversely affect the market for municipal obligations and, consequently, reduce the demand for financial guaranty insurance and reinsurance of such obligations.
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Changes in U.S. federal, state or local laws that materially adversely affect the tax treatment of municipal securities or the market for those securities, or other changes negatively affecting the municipal securities market, also may adversely impact the Company's investment portfolio, a significant portion of which is invested in tax-exempt instruments. These adverse changes may adversely affect the value of the Company's tax-exempt portfolio, or its liquidity.
Certain of the Company's foreign subsidiaries may be subject to U.S. tax.
The Company manages its business so that AGL and its foreign subsidiaries (other than AGRO and AGE) operate in such a manner that none of them should be subject to U.S. federal tax (other than U.S. excise tax on insurance and reinsurance premium income attributable to insuring or reinsuring U.S. risks, and U.S. withholding tax on certain U.S. source investment income). However, because there is considerable uncertainty as to the activities which constitute being engaged in a trade or business within the U.S., the Company cannot be certain that the IRS will not contend successfully that AGL or any of its foreign subsidiaries (other than AGRO and AGE) is/are engaged in a trade or business in the U.S. If AGL and its foreign subsidiaries (other than AGRO and AGE) were considered to be engaged in a trade or business in the U.S., each such company could be subject to U.S. corporate income and branch profits taxes on the portion of its earnings effectively connected to such U.S. business.
AGL, AG Re and AGRO may become subject to taxes in Bermuda after March 2035, which may have a material adverse effect on the Company's results of operations and on an investment in the Company.
The Bermuda Minister of Finance, under Bermuda's Exempted Undertakings Tax Protection Act 1966, as amended, has given AGL, AG Re and AGRO an assurance that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then subject to certain limitations the imposition of any such tax will not be applicable to AGL, AG Re or AGRO, or any of AGL's or its subsidiaries' operations, shares, debentures or other obligations until March 31, 2035. Given the limited duration of the Minister of Finance's assurance, the Company cannot be certain that it will not be subject to Bermuda tax after March 31, 2035.
U.S. Persons who hold 10% or more of AGL's shares directly or through foreign entities may be subject to taxation under the U.S. controlled foreign corporation rules.
Each 10% U.S. shareholder of a foreign corporation that is a controlled foreign corporation ("CFC") for an uninterrupted period of 30 days or more during a taxable year, and who owns shares in the foreign corporation directly or indirectly through foreign entities on the last day of the foreign corporation's taxable year on which it is a CFC, must include in its gross income for U.S. federal income tax purposes its pro rata share of the CFC's "subpart F income," even if the subpart F income is not distributed. In addition, upon a sale of shares of a CFC, 10% U.S. shareholders may be subject to U.S. federal income tax on a portion of their gain at ordinary income rates.
The Company believes that because of the dispersion of the share ownership in AGL, provisions in AGL's Bye-Laws that limit voting power, contractual limits on voting power and other factors, no U.S. Person who owns AGL's shares directly or indirectly through foreign entities should be treated as a 10% U.S. shareholder of AGL or of any of its foreign subsidiaries. It is possible, however, that the IRS could challenge the effectiveness of these provisions and that a court could sustain such a challenge, in which case such U.S. Person may be subject to taxation under U.S. tax rules.
U.S. Persons who hold shares may be subject to U.S. income taxation at ordinary income rates on their proportionate share of the Company's related person insurance income.
If the following conditions are true, then a U.S. Person who owns AGL's shares (directly or indirectly through foreign entities) on the last day of the taxable year would be required to include in its income for U.S. federal income tax purposes such person's pro rata share of the RPII of such Foreign Insurance Subsidiary (as defined below) for the entire taxable year, determined as if such RPII were distributed proportionately only to U.S. Persons at that date, regardless of whether such income is distributed:
• | the Company is 25% or more owned directly, indirectly through foreign entities or by attribution by U.S. Persons; |
• | the gross RPII of AG Re or any other AGL foreign subsidiary engaged in the insurance business that has not made an election under section 953(d) of the Code to be treated as a U.S. corporation for all U.S. tax purposes or are CFCs owned directly or indirectly by AGUS (each, with AG Re, a "Foreign Insurance Subsidiary") were to equal or exceed 20% of such Foreign Insurance Subsidiary's gross insurance income in any taxable year; and |
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• | direct or indirect insureds (and persons related to such insureds) own (or are treated as owning directly or indirectly through entities) 20% or more of the voting power or value of the Company's shares. |
In addition, any RPII that is includible in the income of a U.S. tax-exempt organization may be treated as unrelated business taxable income.
The amount of RPII earned by a Foreign Insurance Subsidiary (generally, premium and related investment income from the direct or indirect insurance or reinsurance of any direct or indirect U.S. holder of shares or any person related to such holder) will depend on a number of factors, including the geographic distribution of a Foreign Insurance Subsidiary's business and the identity of persons directly or indirectly insured or reinsured by a Foreign Insurance Subsidiary. The Company believes that each of its Foreign Insurance Subsidiaries either should not in the foreseeable future have RPII income which equals or exceeds 20% of its gross insurance income or have direct or indirect insureds, as provided for by RPII rules, that directly or indirectly own 20% or more of either the voting power or value of AGL's shares. However, the Company cannot be certain that this will be the case because some of the factors which determine the extent of RPII may be beyond its control.
U.S. Persons who dispose of AGL's shares may be subject to U.S. income taxation at dividend tax rates on a portion of their gain, if any.
The meaning of the RPII provisions and the application thereof to AGL and its Foreign Insurance Subsidiaries is uncertain. The RPII rules in conjunction with section 1248 of the Code provide that if a U.S. Person disposes of shares in a foreign insurance corporation in which U.S. Persons own (directly, indirectly, through foreign entities or by attribution) 25% or more of the shares (even if the amount of gross RPII is less than 20% of the corporation's gross insurance income and the ownership of its shares by direct or indirect insureds and related persons is less than the 20% threshold), any gain from the disposition will generally be treated as dividend income to the extent of the holder's share of the corporation's undistributed earnings and profits that were accumulated during the period that the holder owned the shares. This provision applies whether or not such earnings and profits are attributable to RPII. In addition, such a holder will be required to comply with certain reporting requirements, regardless of the amount of shares owned by the holder.
In the case of AGL's shares, these RPII rules should not apply to dispositions of shares because AGL is not itself directly engaged in the insurance business. However, the RPII provisions have never been interpreted by the courts or the U.S. Treasury Department in final regulations, and regulations interpreting the RPII provisions of the Code exist only in proposed form. It is not certain whether these regulations will be adopted in their proposed form, what changes or clarifications might ultimately be made thereto, or whether any such changes, as well as any interpretation or application of the RPII rules by the IRS, the courts, or otherwise, might have retroactive effect. The U.S. Treasury Department has authority to impose, among other things, additional reporting requirements with respect to RPII.
U.S. Persons who hold common shares will be subject to adverse tax consequences if AGL is considered to be a "passive foreign investment company" for U.S. federal income tax purposes.
If AGL is considered a passive foreign investment company ("PFIC") for U.S. federal income tax purposes, a U.S. Person who owns any shares of AGL will be subject to adverse tax consequences that could materially adversely affect its investment, including subjecting the investor to both a greater tax liability than might otherwise apply and an interest charge. The Company believes that AGL is not, and currently does not expect AGL to become, a PFIC for U.S. federal income tax purposes; however, there can be no assurance that AGL will not be deemed a PFIC by the IRS.
There are currently no regulations regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying these rules may be forthcoming. The Company cannot predict what impact, if any, such guidance would have on an investor that is subject to U.S. federal income taxation.
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Changes in U.S. federal income tax law could materially adversely affect an investment in AGL's common shares.
Legislation has been introduced in the U.S. Congress intended to eliminate certain perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the U.S. but have certain U.S. connections. For example, legislation has been introduced in Congress to limit the deductibility of reinsurance premiums paid by U.S. insurance companies to foreign affiliates and impose additional limits on deductibility of interest of foreign owned U.S. corporations. Another legislative proposal would treat a foreign corporation that is primarily managed and controlled in the U.S. as a U.S. corporation for U.S federal income tax purposes. Further, legislation has previously been introduced to override the reduction or elimination of the U.S. withholding tax on certain U.S. source investment income under a tax treaty in the case of a deductible related party payment made by a U.S. member of a foreign controlled group to a foreign member of the group organized in a tax treaty country to the extent that the ultimate foreign parent corporation would not enjoy the treaty benefits with respect to such payments. It is possible that this or similar legislation could be introduced in and enacted by the current Congress or future Congresses that could have an adverse impact on the Company or the Company's shareholders.
U.S. federal income tax laws and interpretations regarding whether a company is engaged in a trade or business within the U.S. is a PFIC, or whether U.S. Persons would be required to include in their gross income the "subpart F income" of a CFC or RPII are subject to change, possibly on a retroactive basis. There currently are no regulations regarding the application of the PFIC rules to insurance companies, and the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying such rules may be forthcoming. The Company cannot be certain if, when, or in what form such regulations or pronouncements may be implemented or made, or whether such guidance will have a retroactive effect.
Recharacterization by the Internal Revenue Service of the Company's U.S. federal tax treatment of losses on the Company's CDS portfolio can adversely affect the Company's financial position.
As part of the Company's financial guaranty business, the Company has sold credit protection by insuring CDS entered into with various financial institutions. Assured Guaranty's CDS portfolio has experienced significant cumulative fair value losses which are only deductible for U.S. federal income tax purposes upon realization and, consequently, generate a significant deferred tax asset based on the Company's intended treatment of such losses as ordinary insurance losses upon realization. The U.S. federal income tax treatment of CDS is an unsettled area of the tax law. As such, it is possible that the Internal Revenue Service may decide that the losses generated by the Company's CDS business should be characterized as capital rather than ordinary insurance losses, which could materially adversely affect the Company's financial condition.
An ownership change under Section 382 of the Code could have adverse U.S. federal tax consequences.
If AGL were to issue equity securities in the future, including in connection with any strategic transaction, or if previously issued securities of AGL were to be sold by the current holders, AGL may experience an "ownership change" within the meaning of Section 382 of the Code. In general terms, an ownership change would result from transactions increasing the aggregate ownership of certain stockholders in AGL's stock by more than 50 percentage points over a testing period (generally three years). If an ownership change occurred, the Company's ability to use certain tax attributes, including certain built-in losses, credits, deductions or tax basis and/or the Company's ability to continue to reflect the associated tax benefits as assets on AGL's balance sheet, may be limited. The Company cannot give any assurance that AGL will not undergo an ownership change at a time when these limitations could materially adversely affect the Company's financial condition.
AGMH likely experienced an ownership change under Section 382 of the Code.
In connection with the acquisition of AGMH, AGMH likely experienced an "ownership change" within the meaning of Section 382 of the Code. The Company has concluded that the Section 382 limitations as discussed in "An ownership change under Section 382 of the Code could have adverse U.S. federal tax consequences" are unlikely to have any material tax or accounting consequences. However, this conclusion is based on a variety of assumptions, including the Company's estimates regarding the amount and timing of certain deductions and future earnings, any of which could be incorrect. Accordingly, there can be no assurance that these limitations would not have an adverse effect on the Company's financial condition or that such adverse effects would not be material.
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A change in AGL’s U.K. tax residence or its ability to otherwise qualify for the benefits of income tax treaties to which the U.K. is a party could adversely affect an investment in AGL’s common shares.
AGL is not incorporated in the U.K. and, accordingly, is only resident in the U.K. for U.K. tax purposes if it is “centrally managed and controlled” in the U.K. Central management and control constitutes the highest level of control of a company’s affairs. AGL believes it is entitled to take advantage of the benefits of income tax treaties to which the U.K. is a party on the basis that it is has established central management and control in the U.K. AGL has obtained confirmation that there is a low risk of challenge to its residency status from HMRC under the facts as they stand today. The board of directors intends to manage the affairs of AGL in such a way as to maintain its status as a company that is tax-resident in the U.K. for U.K. tax purposes and to qualify for the benefits of income tax treaties to which the U.K. is a party. However, the concept of central management and control is a case-law concept that is not comprehensively defined in U.K. statute. In addition, it is a question of fact. Moreover, tax treaties may be revised in a way that causes AGL to fail to qualify for benefits thereunder. Accordingly, a change in relevant U.K. tax law or in tax treaties to which the U.K. is a party, or in AGL’s central management and control as a factual matter, or other events, could adversely affect the ability of Assured Guaranty to manage its capital in the efficient manner that it contemplated in establishing U.K. tax residence.
Changes in U.K. tax law or in AGL’s ability to satisfy all the conditions for exemption from U.K. taxation on dividend income or capital gains in respect of its direct subsidiaries could affect an investment in AGL’s common shares.
As a U.K. tax resident, AGL is subject to U.K. corporation tax in respect of its worldwide profits (both income and capital gains), subject to applicable exemptions. The main rate of corporation tax is 21% currently.
• | With respect to income, the dividends that AGL receives from its subsidiaries should be exempt from U.K. corporation tax under the exemption contained in section 931D of the Corporation Tax Act 2009. |
• | With respect to capital gains, if AGL were to dispose of shares in its direct subsidiaries or if it were deemed to have done so, it may realize a chargeable gain for U.K. tax purposes. Any tax charge would be based on AGL’s original acquisition cost. It is anticipated that any such future gain should qualify for exemption under the substantial shareholding exemption in Schedule 7AC to the Taxation of Chargeable Gains Act 1992. However, the availability of such exemption would depend on facts at the time of disposal, in particular the “trading” nature of the activities of the Assured Guaranty group and of the relevant subsidiary. There is no statutory definition of what constitutes “trading” activities for this purpose and in practice reliance is placed on the published guidance of HMRC. |
A change in U.K. tax law or its interpretation by HMRC, or any failure to meet all the qualifying conditions for relevant exemptions from U.K. corporation tax, could affect Assured Guaranty’s financial results of operations or its ability to provide returns to shareholders.
Assured Guaranty's financial results may be affected by measures taken in response to the OECD BEPS project.
On July 19, 2013, the Organisation for Economic Co-operation and Development published its Action Plan on Base Erosion and Profit Shifting (the “BEPS Action Plan”), in an attempt to coordinate multilateral action on international tax rules. The recommended actions include an examination of the definition of a “permanent establishment” and the rules for attributing profit to a permanent establishment. Other recommended actions relate to the goal of ensuring that transfer pricing outcomes are in line with value creation, noting that the current rules may facilitate the transfer of risks or capital away from countries where the economic activity takes place. Any changes in U.S. or U.K. tax law in response to the BEPS Action Plan could adversely affect Assured Guaranty’s liability to tax.
The U.K. government has announced the introduction of a new U.K. tax, the diverted profits tax ("DPT"), which is intended to apply with effect from April 1, 2015 and, in substance, effectively anticipates some of the likely outcomes of the BEPS Action Plan. As proposed, DPT is to be charged at 25% and is an anti-avoidance measure, aimed at protecting the U.K. tax base against the diversion of profits away from the U.K. tax charge. In particular, DPT may apply to profits generated by economic activities carried out in the U.K., that are not taxed in the U.K. by reason of arrangements between companies in the same multinational group and involving a low-tax jurisdiction. It is currently unclear whether DPT would constitute a creditable tax for U.S. foreign tax credit purposes. If any member of the Assured Guaranty group is liable to DPT, this could adversely affect the Company's results of operations.
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An adverse adjustment under U.K. legislation governing the taxation of U.K. tax resident holding companies on the profits of their foreign subsidiaries could adversely impact Assured Guaranty’s tax liability.
Under the U.K. “controlled foreign company” regime, the income profits of non-U.K. resident companies may, in certain circumstances, be attributed to controlling U.K. resident shareholders for U.K. corporation tax purposes. A new CFC regime was introduced with effect for CFC accounting periods beginning on or after January 1, 2013. The non-U.K. resident members of the Assured Guaranty group intend to operate and manage their levels of capital in such a manner that their profits would not be taxed on AGL under the U.K. CFC regime. Assured Guaranty has obtained clearance from HMRC that none of the profits of the non-U.K. resident members of the Assured Guaranty group should be subject to U.K. tax as a result of attribution under the CFC regime on the facts as they currently stand. However, a change in the way in which Assured Guaranty operates or any further change in the CFC regime, resulting in an attribution to AGL of any of the income profits of any of AGL’s non-U.K. resident subsidiaries for U.K. corporation tax purposes, could adversely affect Assured Guaranty’s financial results of operations.
Risks Related to AGL's Common Shares
The market price of AGL's common shares may be volatile, which could cause the value of an investment in the Company to decline.
The market price of AGL's common shares has experienced, and may continue to experience, significant volatility. Numerous factors, including many over which the Company has no control, may have a significant impact on the market price of its common shares. These risks include those described or referred to in this "Risk Factors" section as well as, among other things:
• | investor perceptions of the Company, its prospects and that of the financial guaranty industry and the markets in which the Company operates; |
• | the Company's operating and financial performance; |
• | the Company's access to financial and capital markets to raise additional capital, refinance its debt or replace existing senior secured credit and receivables-backed facilities; |
• | the Company's ability to repay debt; |
• | the Company's dividend policy; |
• | future sales of equity or equity-related securities; |
• | changes in earnings estimates or buy/sell recommendations by analysts; and |
• | general financial, economic and other market conditions. |
In addition, the stock market in recent years has experienced extreme price and trading volume fluctuations that often have been unrelated or disproportionate to the operating performance of individual companies. These broad market fluctuations may adversely affect the price of AGL's common shares, regardless of its operating performance.
Furthermore, future sales or other issuances of AGL equity may adversely affect the market price of its common shares.
AGL's common shares are equity securities and are junior to existing and future indebtedness.
As equity interests, AGL's common shares rank junior to indebtedness and to other non-equity claims on AGL and its assets available to satisfy claims on AGL, including claims in a bankruptcy or similar proceeding. For example, upon liquidation, holders of AGL debt securities and shares of preferred stock and creditors would receive distributions of AGL's available assets prior to the holders of AGL common shares. Similarly, creditors, including holders of debt securities, of AGL's subsidiaries, have priority on the assets of those subsidiaries. Future indebtedness may restrict payment of dividends on the common shares.
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Additionally, unlike indebtedness, where principal and interest customarily are payable on specified due dates, in the case of common shares, dividends are payable only when and if declared by AGL's board of directors or a duly authorized committee of the board. Further, the common shares place no restrictions on its business or operations or on its ability to incur indebtedness or engage in any transactions, subject only to the voting rights available to stockholders generally.
Provisions in the Code and AGL's Bye-Laws may reduce or increase the voting rights of its common shares.
Under the Code, AGL's Bye-Laws and contractual arrangements, certain shareholders have their voting rights limited to less than one vote per share, resulting in other shareholders having voting rights in excess of one vote per share. Moreover, the relevant provisions of the Code may have the effect of reducing the votes of certain shareholders who would not otherwise be subject to the limitation by virtue of their direct share ownership.
More specifically, pursuant to the relevant provisions of the Code, if, and so long as, the common shares of a shareholder are treated as "controlled shares" (as determined under section 958 of the Code) of any U.S. Person (as defined below) and such controlled shares constitute 9.5% or more of the votes conferred by AGL's issued shares, the voting rights with respect to the controlled shares of such U.S. Person (a "9.5% U.S. Shareholder") are limited, in the aggregate, to a voting power of less than 9.5%, under a formula specified in AGL's Bye-Laws. The formula is applied repeatedly until the voting power of all 9.5% U.S. Shareholders has been reduced to less than 9.5%. For these purposes, "controlled shares" include, among other things, all shares of AGL that such U.S. Person is deemed to own directly, indirectly or constructively (within the meaning of section 958 of the Code).
In addition, the Board of Directors may limit a shareholder's voting rights where it deems appropriate to do so to (1) avoid the existence of any 9.5% U.S. Shareholders, and (2) avoid certain material adverse tax, legal or regulatory consequences to the Company or any of the Company's subsidiaries or any shareholder or its affiliates. AGL's Bye-Laws provide that shareholders will be notified of their voting interests prior to any vote taken by them.
As a result of any such reallocation of votes, the voting rights of a holder of AGL common shares might increase above 5% of the aggregate voting power of the outstanding common shares, thereby possibly resulting in such holder becoming a reporting person subject to Schedule 13D or 13G filing requirements under the Securities Exchange Act of 1934. In addition, the reallocation of votes could result in such holder becoming subject to the short swing profit recovery and filing requirements under Section 16 of the Exchange Act.
AGL also has the authority under its Bye-Laws to request information from any shareholder for the purpose of determining whether a shareholder's voting rights are to be reallocated under the Bye-Laws. If a shareholder fails to respond to a request for information or submits incomplete or inaccurate information in response to a request, the Company may, in its sole discretion, eliminate such shareholder's voting rights.
Provisions in AGL's Bye-Laws may restrict the ability to transfer common shares, and may require shareholders to sell their common shares.
AGL's Board of Directors may decline to approve or register a transfer of any common shares (1) if it appears to the Board of Directors, after taking into account the limitations on voting rights contained in AGL's Bye-Laws, that any adverse tax, regulatory or legal consequences to AGL, any of its subsidiaries or any of its shareholders may occur as a result of such transfer (other than such as the Board of Directors considers to be de minimis), or (2) subject to any applicable requirements of or commitments to the New York Stock Exchange ("NYSE"), if a written opinion from counsel supporting the legality of the transaction under U.S. securities laws has not been provided or if any required governmental approvals have not been obtained.
AGL's Bye-Laws also provide that if the Board of Directors determines that share ownership by a person may result in adverse tax, legal or regulatory consequences to the Company, any of the subsidiaries or any of the shareholders (other than such as the Board of Directors considers to be de minimis), then AGL has the option, but not the obligation, to require that shareholder to sell to AGL or to third parties to whom AGL assigns the repurchase right for fair market value the minimum number of common shares held by such person which is necessary to eliminate such adverse tax, legal or regulatory consequences.
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Existing reinsurance agreement terms may make it difficult to effect a change of control of AGL.
Some of the Company's reinsurance agreements have change of control provisions that are triggered if a third party acquires a designated percentage of AGL's shares. If a change of control provision is triggered, the ceding company may recapture some or all of the reinsurance business ceded to the Company in the past. Any such recapture could adversely affect the Company's shareholders' equity, future income or financial strength or debt ratings. These provisions may discourage potential acquisition proposals and may delay, deter or prevent a change of control of AGL, including through transactions that some or all of the shareholders might consider to be desirable.
ITEM 1B. | UNRESOLVED STAFF COMMENTS |
None.
ITEM 2. | PROPERTIES |
The principal executive offices of AGL and AG Re consist of approximately 8,250 square feet of office space located in Hamilton, Bermuda; the lease for this space expires in April 2021 and is renewable at the option of the Company. In addition, the Company occupies approximately 110,000 square feet of office space in New York City; the lease for this office space expires in April 2026. As of December 31, 2014, the Company also occupied another 21,000 square feet of office space in London, Sydney, and two offices in San Francisco and Irvine, California. The Company intends to close the Sydney office on March 31, 2015 and the Irvine office on June 30, 2015. Management believes that the office space is adequate for its current and anticipated needs.
ITEM 3. | LEGAL PROCEEDINGS |
Lawsuits arise in the ordinary course of the Company's business. It is the opinion of the Company's management, based upon the information available, that the expected outcome of litigation against the Company, individually or in the aggregate, will not have a material adverse effect on the Company's financial position or liquidity, although an adverse resolution of litigation against the Company in a fiscal quarter or year could have a material adverse effect on the Company's results of operations in a particular quarter or year.
The Company establishes accruals for litigation and regulatory matters to the extent it is probable that a loss has been incurred and the amount of that loss can be reasonably estimated. For litigation and regulatory matters where a loss may be reasonably possible, but not probable, or is probable but not reasonably estimable, no accrual is established, but if the matter is material, it is disclosed, including matters discussed below. The Company reviews relevant information with respect to its litigation and regulatory matters on a quarterly, and annual basis and updates its accruals, disclosures and estimates of reasonably possible loss based on such reviews.
In addition, in the ordinary course of their respective businesses, certain of the Company's subsidiaries assert claims in legal proceedings against third parties to recover losses paid in prior periods. For example, as described in the "Recovery Litigation," section of Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data, in December 2008, the Company filed a claim in the Supreme Court of the State of New York against an investment manager in a transaction it insured alleging breach of fiduciary duty, gross negligence and breach of contract; discovery on the matter is ongoing. In the past, AGC and AGM have filed complaints against certain sponsors and underwriters of RMBS securities that AGC or AGM had insured, alleging that such persons had breached representations and warranties in the transaction documents, failed to cure or repurchase defective loans and/or violated state securities laws. The amounts, if any, the Company will recover in proceedings to recover losses are uncertain, and recoveries, or failure to obtain recoveries, in any one or more of these proceedings during any quarter or year could be material to the Company's results of operations in that particular quarter or year.
Proceedings Relating to the Company's Financial Guaranty Business
The Company receives subpoenas duces tecum and interrogatories from regulators from time to time.
On November 28, 2011, Lehman Brothers International (Europe) (in administration) ("LBIE") sued AG Financial Products Inc. ("AGFP"), an affiliate of AGC which in the past had provided credit protection to counterparties under credit default swaps. AGC acts as the credit support provider of AGFP under these credit default swaps. LBIE's complaint, which was filed in the Supreme Court of the State of New York, alleged that AGFP improperly terminated nine credit derivative transactions between LBIE and AGFP and improperly calculated the termination payment in connection with the termination of 28 other credit derivative transactions between LBIE and AGFP. AGFP calculated that LBIE owes AGFP approximately
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$30 million in connection with the termination of the credit derivative transactions, whereas LBIE asserted in the complaint that AGFP owes LBIE a termination payment of approximately $1.4 billion. LBIE is seeking unspecified damages. On February 3, 2012, AGFP filed a motion to dismiss certain of the counts in the complaint, and on March 15, 2013, the court granted AGFP's motion to dismiss the count relating to improper termination of the nine credit derivative transactions and denied AGFP's motion to dismiss the count relating to the remaining transactions. Discovery has been ongoing and motions for summary judgment are due in September 2015. The Company cannot reasonably estimate the possible loss, if any, that may arise from this lawsuit.
On September 25, 2013, Wells Fargo Bank, N.A., as trust administrator of the MASTR Adjustable Rate Mortgages Trust 2007-3, filed an interpleader complaint in the U.S. District Court for the Southern District of New York against AGM, among others, relating to the right of AGM to be reimbursed from certain cashflows for principal claims paid in respect of insured certificates. The Company estimates that an adverse outcome to the interpleader proceeding could increase losses on the transaction by approximately $10 - $20 million, net of expected settlement payments and reinsurance in force.
Proceedings Resolved Since September 30, 2014
Beginning in July 2008, AGM and various other financial guarantors were named in complaints filed in the Superior Court for the State of California, City and County of San Francisco by a number of plaintiffs. Subsequently, plaintiffs' counsel filed amended complaints against AGM and AGC and added additional plaintiffs. These complaints alleged that the financial guaranty insurer defendants (i) participated in a conspiracy in violation of California's antitrust laws to maintain a dual credit rating scale that misstated the credit default risk of municipal bond issuers and created market demand for municipal bond insurance, (ii) participated in risky financial transactions in other lines of business that damaged each insurer's financial condition (thereby undermining the value of each of their guaranties), and (iii) failed to adequately disclose the impact of those transactions on their financial condition. In addition to their antitrust claims, various plaintiffs asserted claims for breach of the covenant of good faith and fair dealing, fraud, unjust enrichment, negligence, and negligent misrepresentation. On October 29, 2014, AGC and AGM filed a good faith settlement notice with the Superior Court for the State of California, City and County of San Francisco, informing the court and co-defendants that AGC, AGM and the plaintiffs had reached an agreement to settle and resolve the cases as between them. The plaintiffs agreed to dismiss the litigation in exchange for AGC and AGM waiving legal fees that had been awarded to them and making a payment to such plaintiffs. On December 12, 2014, the court entered an order determining that the parties had settled in good faith. Plaintiffs have submitted all appropriate dismissals to all courts, and AGC and AGM have submitted a dismissal for their cross-appeal.
On November 19, 2012, Lehman Brothers Holdings Inc. (“LBHI”) and Lehman Brothers Special Financing Inc. (“LBSF") commenced an adversary complaint and claim objection in the United States Bankruptcy Court for the Southern District of New York against Credit Protection Trust 283 (“CPT 283”), FSA Administrative Services, LLC, as trustee for CPT 283, and AGM, in connection with CPT 283's termination of a CDS between LBSF and CPT 283. CPT 283 terminated the CDS as a consequence of LBSF failing to make a scheduled payment owed to CPT 283, which termination occurred after LBHI filed for bankruptcy but before LBSF filed for bankruptcy. The CDS provided that CPT 283 was entitled to receive from LBSF a termination payment in that circumstance of approximately $43.8 million (representing the economic equivalent of the future fixed payments CPT 283 would have been entitled to receive from LBSF had the CDS not been terminated), and CPT 283 filed proofs of claim against LBSF and LBHI (as LBSF's credit support provider) for such amount. LBHI and LBSF sought to disallow and expunge (as impermissible and unenforceable penalties) CPT 283's proofs of claim against LBHI and LBSF and recover approximately $67.3 million, which LBHI and LBSF allege was the mark-to-market value of the CDS to LBSF (less unpaid amounts) on the day CPT 283 terminated the CDS, plus interest, attorney's fees, costs and other expenses. On the same day, LBHI and LBSF also commenced an adversary complaint and claim objection against Credit Protection Trust 207 (“CPT 207”), FSA Administrative Services, LLC, as trustee for CPT 207, and AGM, in connection with CPT 207's termination of a CDS between LBSF and CPT 207. Similarly, the CDS provided that CPT 207 was entitled to receive from LBSF a termination payment in that circumstance of $492,555. LBHI and LBSF sought to disallow and expunge CPT 207's proofs of claim against LBHI and LBSF and recover approximately $1.5 million. On January 30, 2015, the parties signed an agreement pursuant to which LBHI and LBSF dismissed their litigation related to CPT 283's and CPT 207's CDS terminations and the parties agreed that CPT 283 and CPT 207 have a total allowed claim in bankruptcy against LBSF and LBHI of $20 million.
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Proceedings Related to AGMH's Former Financial Products Business
The following is a description of legal proceedings involving AGMH's former Financial Products Business. Although the Company did not acquire AGMH's former Financial Products Business, which included AGMH's former GIC business, medium term notes business and portions of the leveraged lease businesses, certain legal proceedings relating to those businesses are against entities that the Company did acquire. While Dexia SA and DCL, jointly and severally, have agreed to indemnify the Company against liability arising out of the proceedings described below in the "—Proceedings Related to AGMH's Former Financial Products Business" section, such indemnification might not be sufficient to fully hold the Company harmless against any injunctive relief or civil or criminal sanction that is imposed against AGMH or its subsidiaries.
Governmental Investigations into Former Financial Products Business
AGMH and/or AGM have received subpoenas duces tecum and interrogatories or civil investigative demands from the Attorneys General of the States of Connecticut, Florida, Illinois, Massachusetts, Missouri, New York, Texas and West Virginia relating to their investigations of alleged bid rigging of municipal GICs. AGMH has been responding to such requests. AGMH may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators regarding their inquiries in the future. In addition:
• | AGMH received a subpoena from the Antitrust Division of the Department of Justice in November 2006 issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives; and |
• | AGM received a subpoena from the SEC in November 2006 related to an ongoing industry-wide investigation concerning the bidding of municipal GICs and other municipal derivatives. |
Pursuant to the subpoenas, AGMH has furnished to the Department of Justice and SEC records and other information with respect to AGMH's municipal GIC business. The ultimate loss that may arise from these investigations remains uncertain.
In July 2010, a former employee of AGM who had been involved in AGMH's former Financial Products Business was indicted along with two other persons with whom he had worked at Financial Guaranty Insurance Company. Such former employee and the other two persons were convicted on fraud conspiracy counts. After appeal, their convictions were reversed by a three-judge panel of the U.S. Court of Appeals for the Second Circuit in November 2013. In January 2014, the Department of Justice petitioned the U.S. Court of Appeals for the Second Circuit for a panel rehearing or a rehearing en banc of the appeal; the motion was denied on August 15, 2014, and the time period within which to petition for a writ of certiorari to the Supreme Court has expired.
Lawsuits Relating to Former Financial Products Business
During 2008, nine putative class action lawsuits were filed in federal court alleging federal antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. These cases have been coordinated and consolidated for pretrial proceedings in the U.S. District Court for the Southern District of New York as MDL 1950, In re Municipal Derivatives Antitrust Litigation, Case No. 1:08-cv-2516 ("MDL 1950").
Five of these cases named both AGMH and AGM: (a) Hinds County, Mississippi v. Wachovia Bank, N.A.; (b) Fairfax County, Virginia v. Wachovia Bank, N.A.; (c) Central Bucks School District, Pennsylvania v. Wachovia Bank, N.A.; (d) Mayor and City Council of Baltimore, Maryland v. Wachovia Bank, N.A.; and (e) Washington County, Tennessee v. Wachovia Bank, N.A. In April 2009, the MDL 1950 court granted the defendants' motion to dismiss on the federal claims, but granted leave for the plaintiffs to file an amended complaint. The Corrected Third Consolidated Amended Class Action Complaint, filed on October 9, 2013, lists neither AGM nor AGMH as a named defendant or a co-conspirator. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees and other costs. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from these lawsuits.
Four of the cases named AGMH (but not AGM) and also alleged that the defendants violated California state antitrust law and common law by engaging in illegal bid-rigging and market allocation, thereby depriving the cities or municipalities of competition in the awarding of GICs and ultimately resulting in the cities paying higher fees for these products: (f) City of Oakland, California v. AIG Financial Products Corp.; (g) County of Alameda, California v. AIG Financial Products Corp.; (h) City of Fresno, California v. AIG Financial Products Corp.; and (i) Fresno County Financing Authority v. AIG Financial Products Corp. When the four plaintiffs filed a consolidated complaint in September 2009, the plaintiffs did not name AGMH
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as a defendant. However, the complaint does describe some of AGMH's and AGM's activities. The consolidated complaint generally seeks unspecified monetary damages, interest, attorneys' fees and other costs. In April 2010, the MDL 1950 court granted in part and denied in part the named defendants' motions to dismiss this consolidated complaint.
In 2008, AGMH and AGM also were named in five non-class action lawsuits originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry: (a) City of Los Angeles, California v. Bank of America, N.A.; (b) City of Stockton, California v. Bank of America, N.A.; (c) County of San Diego, California v. Bank of America, N.A.; (d) County of San Mateo, California v. Bank of America, N.A.; and (e) County of Contra Costa, California v. Bank of America, N.A. Amended complaints in these actions were filed in September 2009, adding a federal antitrust claim and naming AGM (but not AGMH) and AGUS, among other defendants. These cases have been transferred to the Southern District of New York and consolidated with MDL 1950 for pretrial proceedings.
In late 2009, AGM and AGUS, among other defendants, were named in six additional non-class action cases filed in federal court, which also have been coordinated and consolidated for pretrial proceedings with MDL 1950: (f) City of Riverside, California v. Bank of America, N.A.; (g) Sacramento Municipal Utility District v. Bank of America, N.A.; (h) Los Angeles World Airports v. Bank of America, N.A.; (i) Redevelopment Agency of the City of Stockton v. Bank of America, N.A.; (j) Sacramento Suburban Water District v. Bank of America, N.A.; and (k) County of Tulare, California v. Bank of America, N.A.
The MDL 1950 court denied AGM and AGUS's motions to dismiss these eleven complaints in April 2010. Amended complaints were filed in May 2010. On October 29, 2010, AGM and AGUS were voluntarily dismissed with prejudice from the Sacramento Municipal Utility District case only. The complaints in these lawsuits generally seek or sought unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from the remaining lawsuits.
In May 2010, AGM and AGUS, among other defendants, were named in five additional non-class action cases filed in federal court in California: (a) City of Richmond, California v. Bank of America, N.A. (filed on May 18, 2010, N.D. California); (b) City of Redwood City, California v. Bank of America, N.A. (filed on May 18, 2010, N.D. California); (c) Redevelopment Agency of the City and County of San Francisco, California v. Bank of America, N.A. (filed on May 21, 2010, N.D. California); (d) East Bay Municipal Utility District, California v. Bank of America, N.A. (filed on May 18, 2010, N.D. California); and (e) City of San Jose and the San Jose Redevelopment Agency, California v. Bank of America, N.A (filed on May 18, 2010, N.D. California). These cases have also been transferred to the Southern District of New York and consolidated with MDL 1950 for pretrial proceedings. In September 2010, AGM and AGUS, among other defendants, were named in a sixth additional non-class action filed in federal court in New York, but which alleges violation of New York's Donnelly Act in addition to federal antitrust law: Active Retirement Community, Inc. d/b/a Jefferson's Ferry v. Bank of America, N.A. (filed on September 21, 2010, E.D. New York), which has also been transferred to the Southern District of New York and consolidated with MDL 1950 for pretrial proceedings. In December 2010, AGM and AGUS, among other defendants, were named in a seventh additional non-class action filed in federal court in the Central District of California, Los Angeles Unified School District v. Bank of America, N.A., and in an eighth additional non-class action filed in federal court in the Southern District of New York, Kendal on Hudson, Inc. v. Bank of America, N.A. These cases also have been consolidated with MDL 1950 for pretrial proceedings. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from these lawsuits.
In January 2011, AGM and AGUS, among other defendants, were named in an additional non-class action case filed in federal court in New York, which alleges violation of New York's Donnelly Act in addition to federal antitrust law: Peconic Landing at Southold, Inc. v. Bank of America, N.A. This case has been consolidated with MDL 1950 for pretrial proceedings. The complaint in this lawsuit generally seeks unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from this lawsuit.
In September 2009, the Attorney General of the State of West Virginia filed a lawsuit (Circuit Ct. Mason County, W. Va.) against Bank of America, N.A. alleging West Virginia state antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. An amended complaint in this action was filed in June 2010, adding a federal antitrust claim and naming AGM (but not AGMH) and AGUS, among other defendants. This case has been removed to federal court as well as transferred to the S.D.N.Y. and consolidated with MDL 1950 for pretrial proceedings. AGM and AGUS answered West Virginia’s Second Amended Complaint on November 11, 2013. The complaint in this lawsuit generally seeks civil penalties, unspecified monetary damages, interest, attorneys' fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from this lawsuit.
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ITEM 4. | MINE SAFETY DISCLOSURES |
Not applicable.
Executive Officers of the Company
The table below sets forth the names, ages, positions and business experience of the executive officers of Assured Guaranty Ltd.
Name | Age | Position(s) | |
Dominic J. Frederico | 62 | President and Chief Executive Officer; Deputy Chairman | |
James M. Michener | 62 | General Counsel and Secretary | |
Robert B. Mills | 65 | Chief Operating Officer * | |
Russell B. Brewer II | 57 | Chief Surveillance Officer | |
Robert A. Bailenson | 48 | Chief Financial Officer | |
Bruce E. Stern | 60 | Executive Officer | |
Howard W. Albert | 55 | Chief Risk Officer | |
* | On February 4, 2015, Assured Guaranty Ltd. agreed with Robert B. Mills, the Company’s current Chief Operating Officer, that the position of Chief Operating Officer would be eliminated, and as a result, Mr. Mills would separate from the Company effective March 31, 2015. |
Dominic J. Frederico has been President and Chief Executive Officer of AGL since December 2003. Mr. Frederico served as Vice Chairman of ACE Limited from June 2003 until April 2004 and served as President and Chief Operating Officer of ACE Limited and Chairman of ACE INA Holdings, Inc. from November 1999 to June 2003. Mr. Frederico was a director of ACE Limited from 2001 until his retirement from that board in May 2005. Mr. Frederico has also served as Chairman, President and Chief Executive Officer of ACE INA Holdings, Inc. from May 1999 through November 1999. Mr. Frederico previously served as President of ACE Bermuda Insurance Ltd. from July 1997 to May 1999, Executive Vice President, Underwriting from December 1996 to July 1997, and as Executive Vice President, Financial Lines from January 1995 to December 1996. Prior to joining ACE Limited, Mr. Frederico spent 13 years working for various subsidiaries of American International Group ("AIG"). Mr. Frederico completed his employment at AIG after serving as Senior Vice President and Chief Financial Officer of AIG Risk Management. Before that, Mr. Frederico was Executive Vice President and Chief Financial Officer of UNAT, a wholly owned subsidiary of AIG headquartered in Paris, France.
James M. Michener has been General Counsel and Secretary of AGL since February 2004. Prior to joining Assured Guaranty, Mr. Michener was General Counsel and Secretary of Travelers Property Casualty Corp. from January 2002 to February 2004. From April 2001 to January 2002, Mr. Michener served as general counsel of Citigroup's Emerging Markets business. Prior to joining Citigroup's Emerging Markets business, Mr. Michener was General Counsel of Travelers Insurance from April 2000 to April 2001 and General Counsel of Travelers Property Casualty Corp. from May 1996 to April 2000.
Robert B. Mills has been Chief Operating Officer of AGL since June 2011. Mr. Mills was Chief Financial Officer of AGL from January 2004 until June 2011. Prior to joining Assured Guaranty, Mr. Mills was Managing Director and Chief Financial Officer—Americas of UBS AG and UBS Investment Bank from April 1994 to January 2004, where he was also a member of the Investment Bank Board of Directors. Previously, Mr. Mills was with KPMG from 1971 to 1994, where his responsibilities included being partner-in-charge of the Investment Banking and Capital Markets practice.
Russell B. Brewer II has been Chief Surveillance Officer of AGL since November 2009 and Chief Surveillance Officer of AGC and AGM since July 2009. Mr. Brewer has been with AGM since 1986. Mr. Brewer was Chief Risk Management Officer of AGM from September 2003 until July 2009 and Chief Underwriting Officer of AGM from September 1990 until September 2003. Mr. Brewer was also a member of the Executive Management Committee of AGM. He was a Managing Director of AGMH from May 1999 until July 2009. From March 1989 to August 1990, Mr. Brewer was Managing Director, Asset Finance Group, of AGM. Prior to joining AGM, Mr. Brewer was an Associate Director of Moody's Investors Service, Inc.
Robert A. Bailenson has been Chief Financial Officer of AGL since June 2011. Mr. Bailenson has been with Assured Guaranty and its predecessor companies since 1990. Mr. Bailenson became Chief Accounting Officer of AGM in July 2009 and has been Chief Accounting Officer of AGL since May 2005 and Chief Accounting Officer of AGC since 2003. He was Chief
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Financial Officer and Treasurer of AG Re from 1999 until 2003 and was previously the Assistant Controller of Capital Re Corp., the Company's predecessor.
Bruce E. Stern has been Executive Officer of AGC and AGM since July 2009. Mr. Stern was General Counsel, Managing Director and Secretary of AGM from 1987 until July 2009. Mr. Stern was also a member of the Executive Management Committee of AGM. Prior to joining AGM, Mr. Stern was an associate at the New York office of Cravath, Swaine & Moore. Mr. Stern has served as Chairman of the Association of Financial Guaranty Insurers since April 2010.
Howard W. Albert has been Chief Risk Officer of AGL since May 2011. Prior to that, he was Chief Credit Officer of AGL from 2004 to April 2011. Mr. Albert joined Assured Guaranty in September 1999 as Chief Underwriting Officer of Capital Re Company, the predecessor to AGC. Before joining Assured Guaranty, he was a Senior Vice President with Rothschild Inc. from February 1997 to August 1999. Prior to that, he spent eight years at Financial Guaranty Insurance Company from May 1989 to February 1997, where he was responsible for underwriting guaranties of asset-backed securities and international infrastructure transactions. Prior to that, he was employed by Prudential Capital, an investment arm of The Prudential Insurance Company of America, from September 1984 to April 1989, where he underwrote investments in asset-backed securities, corporate loans and project financings.
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PART II
ITEM 5. | MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
AGL's common shares are listed on the New York Stock Exchange under symbol "AGO." The table below sets forth, for the calendar quarters indicated, the reported high and low sales prices and amount of any cash dividends declared.
Common Stock Prices and Dividends
2014 | 2013 | ||||||||||||||||||||||
Sales Price | Cash | Sales Price | Cash | ||||||||||||||||||||
High | Low | Dividends | High | Low | Dividends | ||||||||||||||||||
First Quarter | $ | 26.76 | $ | 20.44 | $ | 0.11 | $ | 21.30 | $ | 13.95 | $ | 0.10 | |||||||||||
Second Quarter | 26.78 | 23.10 | 0.11 | 24.73 | 18.92 | 0.10 | |||||||||||||||||
Third Quarter | 24.91 | 21.61 | 0.11 | 23.64 | 18.42 | 0.10 | |||||||||||||||||
Fourth Quarter | 26.79 | 20.02 | 0.11 | 24.81 | 17.80 | 0.10 | |||||||||||||||||
On February 23, 2015, the closing price for AGL's common shares on the NYSE was $26.38, and the approximate number of shareholders of record at the close of business on that date was 86.
AGL is a holding company whose principal source of income is dividends from its operating subsidiaries. The ability of the operating subsidiaries to pay dividends to AGL and AGL's ability to pay dividends to its shareholders are each subject to legal and regulatory restrictions. The declaration and payment of future dividends will be at the discretion of AGL's Board of Directors and will be dependent upon the Company's profits and financial requirements and other factors, including legal restrictions on the payment of dividends and such other factors as the Board of Directors deems relevant. For more information concerning AGL's dividends, please refer to Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations under the caption "Liquidity and Capital Resources" and Note 12, Insurance Company Regulatory Requirements, of the Financial Statements and Supplementary Data.
2014 Share Purchases
In 2014, the Company repurchased its common shares under a $400 million authorization approved on November 11, 2013 that replaced its prior authorization, and an incremental $400 million authorization approved on August 6, 2014. In 2014, the Company repurchased a total of 24.4 million common shares for approximately $590 million, at an average price of $24.17 per share.
The Company expects the repurchases to be made from time to time in the open market or in privately negotiated transactions. The timing, form and amount of the share repurchases under the program are at the discretion of management and will depend on a variety of factors, including availability of funds at the holding companies, market conditions, the Company's capital position, legal requirements and other factors. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. It does not have an expiration date.
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Issuer’s Purchases of Equity Securities
The following table reflects purchases of AGL common shares made by the Company during Fourth Quarter 2014.
Period | Total Number of Shares Purchased | Average Price Paid Per Share | Total Number of Shares Purchased as Part of Publicly Announced Program (1) | Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Program(2) | ||||||||||
October 1 - October 31 | 2,641,854 | $ | 22.04 | 2,641,854 | $ | 303,875,524 | ||||||||
November 1 - November 30 | 1,641,333 | $ | 24.35 | 1,641,333 | $ | 263,913,812 | ||||||||
December 1 - December 31 | 2,105,000 | $ | 25.67 | 2,105,000 | $ | 209,872,429 | ||||||||
Total | 6,388,187 | $ | 23.83 | 6,388,187 | ||||||||||
____________________
(1) | After giving effect to repurchases since the beginning of 2013 through February 26, 2015, the Company has repurchased a total of 40.5 million common shares for approximately $946 million, excluding commissions, at an average price of $23.36 per share. On August 6, 2014, the Company's board of directors approved an incremental $400 million share repurchase authorization, out of which $118 million of capacity to repurchase remains as of the filing date. |
(2) | Excludes commissions. |
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Performance Graph
Set forth below are a line graph and a table comparing the dollar change in the cumulative total shareholder return on AGL's common shares from December 31, 2009 through December 31, 2014 as compared to the cumulative total return of the Standard & Poor's 500 Stock Index and the cumulative total return of the Standard & Poor's 500 Financials Index. The chart and table depict the value on December 31, 2009, December 31, 2010, December 31, 2011, December 31, 2012, December 31, 2013 and December 31, 2014 of a $100 investment made on December 31, 2009, with all dividends reinvested:
Assured Guaranty | S&P 500 Index | S&P 500 Financial Index | |||||||||
12/31/2009 | $ | 100.00 | $ | 100.00 | $ | 100.00 | |||||
12/31/2010 | 82.17 | 115.06 | 112.13 | ||||||||
12/31/2011 | 61.81 | 117.49 | 93.00 | ||||||||
12/31/2012 | 68.71 | 136.27 | 119.73 | ||||||||
12/31/2013 | 116.01 | 180.40 | 162.34 | ||||||||
12/31/2014 | 130.16 | 205.05 | 186.97 | ||||||||
___________________
Source: Bloomberg
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ITEM 6. | SELECTED FINANCIAL DATA |
The following selected financial data should be read together with the other information contained in this Form 10-K, including "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related notes included elsewhere in this Form 10-K.
Year Ended December 31, | |||||||||||||||||||
2014 | 2013 | 2012 | 2011 | 2010 | |||||||||||||||
(dollars in millions, except per share amounts) | |||||||||||||||||||
Statement of operations data: | |||||||||||||||||||
Revenues: | |||||||||||||||||||
Net earned premiums | $ | 570 | $ | 752 | $ | 853 | $ | 920 | $ | 1,187 | |||||||||
Net investment income | 403 | 393 | 404 | 396 | 361 | ||||||||||||||
Net realized investment gains (losses) | (60 | ) | 52 | 1 | (18 | ) | (2 | ) | |||||||||||
Realized gains and other settlements on credit derivatives | 23 | (42 | ) | (108 | ) | 6 | 153 | ||||||||||||
Net unrealized gains (losses) on credit derivatives | 800 | 107 | (477 | ) | 554 | (155 | ) | ||||||||||||
Fair value gains (losses) on committed capital securities | (11 | ) | 10 | (18 | ) | 35 | 9 | ||||||||||||
Fair value gains (losses) on financial guaranty variable interest entities | 255 | 346 | 191 | (146 | ) | (274 | ) | ||||||||||||
Other income (loss) | 14 | (10 | ) | 108 | 58 | 34 | |||||||||||||
Total revenues | 1,994 | 1,608 | 954 | 1,805 | 1,313 | ||||||||||||||
Expenses: | |||||||||||||||||||
Loss and loss adjustment expenses | 126 | 154 | 504 | 448 | 412 | ||||||||||||||
Amortization of deferred acquisition costs(1) | 25 | 12 | 14 | 17 | 22 | ||||||||||||||
Assured Guaranty Municipal Holdings Inc. acquisition-related expenses | — | — | — | — | 7 | ||||||||||||||
Interest expense | 92 | 82 | 92 | 99 | 100 | ||||||||||||||
Other operating expenses(1) | 220 | 218 | 212 | 212 | 238 | ||||||||||||||
Total expenses | 463 | 466 | 822 | 776 | 779 | ||||||||||||||
Income (loss) before (benefit) provision for income taxes | 1,531 | 1,142 | 132 | 1,029 | 534 | ||||||||||||||
Provision (benefit) for income taxes | 443 | 334 | 22 | 256 | 50 | ||||||||||||||
Net income (loss) | 1,088 | 808 | 110 | 773 | 484 | ||||||||||||||
Earnings (loss) per share: | |||||||||||||||||||
Basic | $ | 6.30 | $ | 4.32 | $ | 0.58 | $ | 4.21 | $ | 2.63 | |||||||||
Diluted | $ | 6.26 | $ | 4.30 | $ | 0.57 | $ | 4.16 | $ | 2.56 | |||||||||
Dividends per share | $ | 0.44 | $ | 0.40 | $ | 0.36 | $ | 0.18 | $ | 0.18 | |||||||||
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As of December 31, | |||||||||||||||||||
2014 | 2013 | 2012 | 2011 | 2010 | |||||||||||||||
(dollars in millions, except per share amounts) | |||||||||||||||||||
Balance sheet data (end of period): | |||||||||||||||||||
Assets: | |||||||||||||||||||
Investments and cash | $ | 11,459 | $ | 10,969 | $ | 11,223 | $ | 11,314 | $ | 10,849 | |||||||||
Premiums receivable, net of commissions payable | 729 | 876 | 1,005 | 1,003 | 1,168 | ||||||||||||||
Ceded unearned premium reserve | 381 | 452 | 561 | 709 | 822 | ||||||||||||||
Salvage and subrogation recoverable | 151 | 174 | 456 | 368 | 1,032 | ||||||||||||||
Credit derivative assets | 68 | 94 | 141 | 153 | 185 | ||||||||||||||
Total assets | 14,925 | 16,287 | 17,242 | 17,709 | 19,370 | ||||||||||||||
Liabilities and shareholders' equity: | |||||||||||||||||||
Unearned premium reserve | 4,261 | 4,595 | 5,207 | 5,963 | 6,973 | ||||||||||||||
Loss and loss adjustment expense reserve | 799 | 592 | 601 | 679 | 574 | ||||||||||||||
Reinsurance balances payable, net | 107 | 148 | 219 | 171 | 274 | ||||||||||||||
Long-term debt | 1,303 | 816 | 836 | 1,038 | 1,053 | ||||||||||||||
Credit derivative liabilities | 963 | 1,787 | 1,934 | 1,457 | 2,055 | ||||||||||||||
Total liabilities | 9,167 | 11,172 | 12,248 | 13,057 | 15,700 | ||||||||||||||
Accumulated other comprehensive income | 370 | 160 | 515 | 368 | 112 | ||||||||||||||
Shareholders' equity | 5,758 | 5,115 | 4,994 | 4,652 | 3,670 | ||||||||||||||
Book value per share | 36.37 | 28.07 | 25.74 | 25.52 | 19.97 | ||||||||||||||
Consolidated statutory financial information(2): | |||||||||||||||||||
Contingency reserve | $ | 2,330 | $ | 2,934 | $ | 2,364 | $ | 2,571 | $ | 2,288 | |||||||||
Policyholders' surplus | 4,142 | 3,202 | 3,579 | 3,116 | 2,627 | ||||||||||||||
Claims-paying resources(3) | 12,189 | 12,147 | 12,328 | 12,839 | 12,630 | ||||||||||||||
Outstanding Exposure: | |||||||||||||||||||
Net debt service outstanding | $ | 609,622 | $ | 690,535 | $ | 780,356 | $ | 844,447 | $ | 926,698 | |||||||||
Net par outstanding | 403,729 | 459,107 | 518,772 | 556,830 | 616,686 | ||||||||||||||
___________________
(1) | Accounting guidance restricting the types and amounts of financial guaranty insurance contract acquisition costs that may be deferred was adopted and retrospectively applied effective January 1, 2012. |
(2) | Prepared in accordance with accounting practices prescribed or permitted by U.S. insurance regulatory authorities, for all insurance subsidiaries. |
(3) | Claims-paying resources is calculated as the sum of statutory policyholders' surplus, statutory contingency reserve, statutory unearned premium reserves, statutory loss and LAE reserves, present value of installment premium on financial guaranty and credit derivatives, discounted at 6%, and standby lines of credit/stop loss. Total claims-paying resources is used by the Company to evaluate the adequacy of capital resources. |
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ITEM 7. | MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the Company’s consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-K. It contains forward looking statements that involve risks and uncertainties. Please see “Forward Looking Statements” for more information. The Company's actual results could differ materially from those anticipated in these forward looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings “Risk Factors” and “Forward Looking Statements.”
Introduction
The Company provides credit protection products to the U.S. and international public finance (including infrastructure) and structured finance markets. The Company applies its credit underwriting judgment, risk management skills and capital markets experience to offer financial guaranty insurance that protects holders of debt instruments and other monetary obligations from defaults in scheduled payments. If an obligor defaults on a scheduled payment due on an obligation, including a scheduled principal or interest payment, the Company is required under its unconditional and irrevocable financial guaranty to pay the amount of the shortfall to the holder of the obligation. The Company markets its financial guaranty insurance directly to issuers and underwriters of public finance and structured finance securities as well as to investors in such obligations. The Company guarantees obligations issued principally in the U.S. and the U.K., and also guarantees obligations issued in other countries and regions, including Australia and Western Europe.
Executive Summary
This executive summary of management’s discussion and analysis highlights selected information and may not contain all of the information that is important to readers of this Annual Report. For a more detailed description of events, trends and uncertainties, as well as the capital, liquidity, credit, operational and market risks and the critical accounting policies and estimates affecting the Company, this Annual Report should be read in its entirety.
Economic Environment
The overall economic environment in the U.S. continued improving during 2014. Although gross domestic product (“GDP”) declined during the first quarter of 2014, GDP growth resumed during the remainder of the year, resulting in full-year GDP growth of 2.4%. The unemployment rate ended the year at 5.6%, a full percentage point below where it began, and the lowest year-end figure since 2007. While U.S. home prices, as measured by the Case-Shiller index, slightly declined in the middle of the year, growth has since resumed, continuing the positive trend that emerged at the beginning of 2012. During 2014, inflation remained below the target level of the Federal Open Market Committee, which continued to hold the federal funds rate near zero. Also during this time period, the interest rate for a widely followed industry index of 30-year municipal bonds fell by 133 basis points. Overall, U.S. prospects for additional economic recovery and higher interest rates are clouded by weak global economic performance and geopolitical risk, accompanied by strengthening of the dollar.
In 2014, most municipalities continued taking steps to address the fiscal challenges they experienced as a result of the global financial crisis of 2008 and the ensuing recession. A recent survey of local government finance officers showed continued improvement in cities’ fiscal health during the year. At the state level, revenues continued to rebound, despite a decline in the second quarter. More generally, stock market gains relieved some pressure on underfunded pension plans, but such gains could be reversed, and many state and local governments continue to have difficulty funding pension and other obligations owed to municipal workers. During the last several years, although municipal defaults were rare, a small number of municipalities sought, though did not always obtain, bankruptcy protection. In 2014, fiscal pressure stemming from Puerto Rico’s weak economy led to downgrades of the Commonwealth and related debt to levels below investment grade. Outside the U.S., other countries’ economies are generally recovering more slowly from the global financial crisis. This continued to negatively impact the number of new infrastructure financings coming to market, including those appropriate for financial guarantees. The European Central Bank recently announced that it will begin a program of quantitative easing, which is likely to reduce long-term interest rates and therefore stimulate growth. In the United Kingdom, the economy grew at its fastest rate since 2007 despite a moderation in growth during the second half of the year.
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Financial Performance of Assured Guaranty
Financial Results
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions, except per share amounts) | |||||||||||
Net income (loss) | $ | 1,088 | $ | 808 | $ | 110 | |||||
Operating income(1) | 491 | 609 | 535 | ||||||||
Net income (loss) per diluted share | 6.26 | 4.30 | 0.57 | ||||||||
Operating income per share(1) | 2.83 | 3.25 | 2.81 | ||||||||
Diluted shares(2) | 173.6 | 187.6 | 190.7 | ||||||||
Present value of new business production (“PVP”)(1) | 168 | 141 | 210 | ||||||||
Gross par written | 13,171 | 9,350 | 16,816 | ||||||||
As of December 31, 2014 | As of December 31, 2013 | |||||||||||||||
Amount | Per Share | Amount | Per Share | |||||||||||||
(in millions, except per share amounts) | ||||||||||||||||
Shareholders' equity | $ | 5,758 | $ | 36.37 | $ | 5,115 | $ | 28.07 | ||||||||
Operating shareholders' equity(1) | 5,933 | 37.48 | 6,164 | 33.83 | ||||||||||||
Adjusted book value(1) | 8,495 | 53.66 | 9,033 | 49.58 | ||||||||||||
Common shares outstanding | 158.3 | 182.2 | ||||||||||||||
____________________
(1) | Please refer to “—Non-GAAP Financial Measures” for a definition of the financial measures that were not determined in accordance with GAAP and a reconciliation of the non-GAAP financial measure and the most directly comparable GAAP financial measure, if available. |
(2) | Same for GAAP net income and non-GAAP operating income. |
Year Ended December 31, 2014
There are several primary drivers of volatility in GAAP reported net income or loss that are not necessarily indicative of credit impairment or improvement, or ultimate economic gains or losses: changes in credit spreads of insured credit derivative obligations and financial guaranty variable interest entities' ("FG VIEs") assets and liabilities, changes in the Company's own credit spreads, and changes in risk-free rates used to discount expected losses. Changes in credit spreads generally have the most significant effect on changes in fair value of credit derivatives and FG VIE assets and liabilities. In addition to these non-economic factors, other factors such as: changes in expected losses, the timing of refunding transactions and terminations, realized gains and losses on the investment portfolio (including other-than-temporary impairments), the effects of large settlements or transactions, and the effects of the Company's various loss mitigation strategies, among others, may also have a significant effect on reported net income or loss in a given reporting period.
Net income for 2014 increased to $1.1 billion from $808 million in 2013. The increase in net income was due primarily to (i) higher net change in fair value gains on credit derivatives and (ii) lower loss expense, partially offset by (i) lower net earned premiums, (ii) net realized investment losses as compared to gains in the prior year and (iii) lower net change in fair value of FG VIEs.
Non-GAAP operating income in 2014 was $491 million, compared with $609 million in 2013. The decrease in operating income was driven primarily by the decrease in net earned premiums and credit derivative revenues due to lower accelerations and scheduled amortization on the insured portfolio. This was offset in part by lower loss expense and higher commutation gains reported in other income.
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Common Share Repurchases
Summary of Share Repurchases
Amount | Number of Shares | Average price per share | ||||||||
(in millions, except per share data) | ||||||||||
2014 | $ | 590 | 24.4 | $ | 24.17 | |||||
2013 | $ | 264 | 12.5 | $ | 21.12 | |||||
Accretive Effect of Cumulative Repurchases(1)
Year Ended December 31, 2014 | As of December 31, 2014 | ||||||
(per share) | |||||||
Net income | $ | 0.71 | |||||
Operating income | 0.32 | ||||||
Shareholders' equity | $ | 2.56 | |||||
Operating shareholders' equity | 2.78 | ||||||
Adjusted book value | 5.84 | ||||||
_________________
(1) | Cumulative repurchases since the beginning of 2013. |
Key Business Strategies
The Company is currently pursuing three primary business strategies, each described in more detail below:
• | New business production and commutations |
• | Capital management |
• | Loss mitigation |
The Company will continue to evaluate its primary business strategies as circumstances warrant.
New Business Production and Commutations
The Company believes high-profile defaults by municipal obligors, such as Detroit, Michigan and Stockton, California, both of which filed for protection under chapter 9 of the U.S. Bankruptcy Code, and the deteriorating financial condition of Puerto Rico, have led to increased awareness of the value of bond insurance and stimulated demand for the product.
The Company also believes the March 2014 upgrade by S&P of the financial strength ratings of AGM, MAC, AGE and AGC to AA (stable outlook) was viewed positively by issuers and investors. S&P cited the Company’s reduced exposure in its legacy RMBS portfolio and noted that the Company’s full payment of claims in municipal bankruptcies demonstrates and reiterates to various constituents the value of bond insurance and the credit position and capacity of the Company. Further, the Company believes that AGM attaining a financial strength rating of AA+ (stable outlook) from KBRA in November 2014, in addition to the AA+ (stable outlook) financial strength rating that KBRA already assigned to MAC, will improve the Company's new business production.
However, the level of the Company's new business production in the U.S. does face some challenges. After a number of years in which the Company was essentially the only active financial guarantor, in 2013 and 2014 a second financial guarantor insured a number of small and medium sized issuances, and in 2014, a third financial guarantor obtained upgraded financial strength ratings from rating agencies and insured several transactions in the primary market. Additionally, the
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Company expects that a persistently low interest rate environment will suppress demand for bond insurance because the potential savings for issuers are less compelling and some investors prefer to forgo insurance in favor of greater yield.
Outside the U.S., the Company believes the U.K. currently presents the most new business opportunities in accordance with the Company's credit policy and risk guidelines. From July 2013 to June 2014, the Company guaranteed four U.K. public-private partnership transactions, the first such wrapped infrastructure bonds issued since 2008. The Company believes that, following the closing of these U.K. transactions, there may be growing demand in a number of countries for financial guarantees of infrastructure financings, which have typically required such guarantees for capital market access. Assured Guaranty believes it is the only company in the private sector offering such financial guarantees outside the United States.
The following tables present summarized information about the U.S. municipal market's new debt issuance volume and the Company's share of that market based on the sale date.
U.S. Municipal Market Data
Based on Sale Date
Year Ended December 31, | ||||||||||||||||||||
2014 | 2013 | 2012 | ||||||||||||||||||
Par | Number of issues | Par | Number of issues | Par | Number of issues | |||||||||||||||
(dollars in billions, except number of issues) | ||||||||||||||||||||
New municipal bonds issued | $ | 314.9 | 10,162 | $ | 311.9 | 10,558 | $ | 366.7 | 12,544 | |||||||||||
Total insured | 18.5 | 1,403 | 12.1 | 1,025 | 13.2 | 1,159 | ||||||||||||||
Insured by AGC, AGM and MAC | 10.7 | 697 | 7.5 | 488 | 13.2 | 1,157 | ||||||||||||||
Industry Penetration Rates
U.S. Municipal Market
Year Ended December 31, | |||||
2014 | 2013 | 2012 | |||
Market penetration par | 5.9% | 3.9% | 3.6% | ||
Market penetration based on number of issues | 13.8 | 9.7 | 9.2 | ||
% of single A par sold | 19.7 | 11.0 | 11.9 | ||
% of single A transactions sold | 49.3 | 30.6 | 29.5 | ||
% of under $25 million par sold | 16.5 | 10.9 | 11.7 | ||
% of under $25 million transactions sold | 15.4 | 10.7 | 10.3 | ||
In general, the Company expects that structured finance opportunities will increase in the future as the global economy recovers, interest rates rise, more issuers return to the capital markets for financings and institutional investors again utilize financial guaranties. The Company considers its involvement in both structured finance and international infrastructure transactions to be a competitive advantage because such transactions diversify both the Company's business opportunities and its risk profile.
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New Business Production
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
PVP(1): | |||||||||||
Public Finance—U.S. | |||||||||||
Assumed from Radian Asset | $ | — | $ | — | $ | 22 | |||||
Direct | 128 | 116 | 144 | ||||||||
Public Finance—non-U.S. | 7 | 18 | 1 | ||||||||
Structured Finance—U.S. | 24 | 7 | 43 | ||||||||
Structured Finance—non-U.S. | 9 | — | — | ||||||||
Total PVP | $ | 168 | $ | 141 | $ | 210 | |||||
Gross Par Written: | |||||||||||
Public Finance—U.S. | |||||||||||
Assumed from Radian Asset | $ | — | $ | — | $ | 1,797 | |||||
Direct | 12,275 | 8,671 | 14,364 | ||||||||
Public Finance—non-U.S. | 128 | 392 | 35 | ||||||||
Structured Finance—U.S. | 418 | 287 | 620 | ||||||||
Structured Finance—non-U.S. | 350 | — | — | ||||||||
Total gross par written | $ | 13,171 | $ | 9,350 | $ | 16,816 | |||||
____________________
(1) | PVP represents the present value of estimated future earnings primarily on new financial guaranty contracts written in the period, before consideration of cessions to reinsurers. PVP and Gross Par Written in the table above are based on close date. See “-Non-GAAP Measures-PVP or Present Value of New Business Production.” |
PVP increased by 19% for FY 2014, compared with FY 2013 due mainly to structured finance PVP attributable to a $400 million insurance reserve financing transaction for a U.S. based life insurance group and a $200 million diversified payment rights transaction for one of Turkey's largest banks, Türkiye Garanti Bankasıi A.Ş.
U.S. public finance PVP was 10% higher in 2014 than in 2013. In the U.S. public finance market, insurance penetration, based on par sold, was 5.9% for FY 2014, compared with 3.9% for FY 2013, with Assured Guaranty once again writing the majority of the insured par. In addition to normal new market issuances, PVP in both 2014 and 2013 includes business written related to debt restructurings.
Several factors affect the ability to generate new business in the U.S municipal market including: the low interest rate environment in the U.S. which results in lower demand for financial guaranty insurance from issuers; the low volume of new issuance in the U.S. public finance market, which results in fewer insurable bonds; increased competition from other financial guaranty insurers, including new entrants; and uncertainty over the financial strength ratings of AGM and AGC. However, the Company believes there will be continued demand for its insurance in this market because for those exposures that the Company guarantees, it undertakes the tasks of credit selection, analysis, negotiation of terms, surveillance and, if necessary, loss mitigation. The Company believes that its insurance encourages retail investors, who typically have fewer resources than the Company for analyzing municipal bonds, to purchase such bonds; enables institutional investors to operate more efficiently; and allows smaller, less well-known issuers to gain market access on a more cost-effective basis.
In 2014, the Company guaranteed a £77 million infrastructure bond issued to finance the new construction and refurbishment of homes in an area in the U.K.
In addition to PVP, in 2014, the Company entered into commutation agreements to reassume ceded business consisting of approximately $1,167 million par of almost exclusively U.S. public finance and European (predominantly U.K.) utility and infrastructure exposures outstanding. For such reassumptions, the Company received the statutory unearned premium outstanding as of the commutation dates plus, in one case, a commutation premium.
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Capital Management
In recent years, the Company has developed strategies for improving the efficiency of its management of capital within the Assured Guaranty group.
In November 2013, AGL became tax resident in the United Kingdom, while remaining a Bermuda-based company and continuing to carry on its administrative and head office functions in Bermuda. As a U.K. tax resident company, AGL is subject to the tax rules applicable to companies resident in the U.K. More information about AGL becoming a U.K. tax resident is set out in the "Tax Matters" section of "Item 1. Business."
On June 20, 2014, AGUS issued 5.0% Senior Notes for net proceeds of $495 million. The net proceeds from the sale of the notes are being used for general corporate purposes, including the purchase of common shares of AGL.
On August 6, 2014, in continuation of the Company's capital management strategy of repurchasing the AGL common shares, AGL's Board of Directors approved an incremental $400 million share repurchase authorization, of which $118 million of capacity remains, on a settlement basis, as of February 26, 2015. In 2014, the Company repurchased a total of 24.4 million common shares for approximately $590 million at an average price of $24.17 per share. The Company expects the repurchases, to be made from time to time in the open market or in privately negotiated transactions. The timing, form and amount of the share repurchases under the program are at the discretion of management and will depend on a variety of factors, including free funds available at the parent company, market conditions, the Company's capital position, legal requirements and other factors. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. It does not have an expiration date. See Note 19, Shareholders' Equity, of the Financial Statements and Supplementary Data, for additional information about the Company's repurchases of its common shares.
In order to reduce leverage, and possibly rating agency capital charges, the Company has mutually agreed with beneficiaries to terminate selected financial guaranty insurance and credit derivative contracts. In particular, the Company has targeted investment grade securities for which claims are not expected but which carry a disproportionately large rating agency capital charge. As noted below under "Loss Mitigation", in some instances, settlements with R&W providers took the form of terminations of below-investment-grade CDS. The Company terminated $4.0 billion in net par in 2014, $7.1 billion in net par in 2013 and $4.1 billion in net par in 2012 of financial guaranty and CDS contracts.
Loss Mitigation
In an effort to recover losses the Company experienced in its insured U.S. RMBS portfolio, the Company pursues R&W providers by enforcing R&W provisions in contracts, negotiating agreements with R&W providers relating to those provisions and, where appropriate, initiating litigation against R&W providers. See Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data, for a discussion of the R&W settlements the Company has entered into and the litigation proceedings the Company has initiated against R&W providers and other parties.
In 2014, R&W development was a positive $268 million attributed to progress made or settlements reached with R&W providers. In some instances, where the entity providing the R&W (or an affiliate of the entity) benefited from credit protection sold by the Company through a CDS, the settlement was in the form of a termination of the CDS protection, allowing the Company to avoid future losses on the CDS. The Company's loss mitigation efforts on its U.S. RMBS exposure over the past several years have resulted in R&W providers paying, or agreeing to pay, or terminating insurance protection on future projected losses of, approximately $4.2 billion (gross of reinsurance) in respect of their R&W liabilities for transactions in which the Company has provided insurance.
In addition, the Company has been focused on the quality of servicing of the mortgage loans underlying its insured RMBS transactions. Servicing influences collateral performance and ultimately the amount (if any) of the Company's insured losses. The Company has a group to mitigate RMBS losses by influencing mortgage servicing, including, if possible, causing the transfer of servicing or establishing special servicing arrangements. “Special servicing” is an industry term referencing more intense servicing applied to delinquent loans aimed at mitigating losses; special servicing arrangements provide incentives to a servicer to achieve better performance on the mortgage loans it services. As of December 31, 2014, the Company's net insured par of the transactions subject to a servicing transfer was $1.8 billion and the total net insured par of the transactions subject to a special servicing arrangement was $2.5 billion.
In the public finance and infrastructure finance arena, the Company has been able to negotiate consensual restructurings with various obligors. During 2014, the Company reached an agreement with respect to its exposures to the City of Detroit, Michigan. The Company reached a settlement with Stockton, California that was included in Stockton's plan of
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adjustment; the plan became effective February 25, 2015. Additionally, the Company has resolved its exposure to other troubled municipal credits, as described in greater detail in Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data, and is an active participant in discussions with the Commonwealth of Puerto Rico and its advisors. During 2013, the Company reached agreements with respect to its exposures to Mashantucket Pequot Tribe; Jefferson County, Alabama; and Harrisburg, Pennsylvania. In connection with the Jefferson County and Harrisburg settlements, the Company insured new revenue bonds for both municipalities, and the premium it was paid was included as part of the 2013 PVP above.
The Company is also continuing to purchase attractively priced BIG obligations that it has insured. These purchases resulted in a reduction of net expected loss to be paid of $541 million as of December 31, 2014. The fair value of assets purchased for loss mitigation purposes in our investment portfolio as of December 31, 2014 (excluding the value of the Company's insurance) was $867 million, with a par of $1,766 million (including bonds related to FG VIEs of $101 million in fair value and $419 million in par).
Agreement to Purchase Radian Asset Assurance Inc.
On December 22, 2014, AGC entered into an agreement to purchase all of the issued and outstanding capital stock of Radian Asset Assurance Inc. ("Radian Asset"), a New York domiciled financial guaranty insurer that ceased writing new business in 2008, for $810 million in cash (subject to adjustment for dividends paid and expenses incurred prior to closing). The Company believes that consummation of the acquisition and the subsequent merger of Radian Asset with and into AGC, which are expected to be completed in the first half of 2015, will enhance the financial condition of AGC and the Company.
The acquisition and the merger are subject to the receipt of consents and approvals from government entities that may not be received or that may impose conditions that could have an adverse effect on the Company following the completion of the acquisition and merger. While the Company believes that it will receive the requisite regulatory approvals from these authorities, and does not currently expect that any such conditions would be imposed, no assurance can be given of this.
The Company’s ability to achieve the expected benefits of the acquisition will depend on, among other things, the Company’s evaluation of Radian Asset’s insured portfolio and estimation of expected losses and the performance of the guaranteed obligations; the ability of the Company’s management to manage Radian Asset’s insured portfolio; and the Company’s ability to integrate Radian Asset’s business and achieve desired operating efficiencies. Failure to achieve the anticipated benefits of the acquisition could result in a reduction in the price of the Company’s common shares as well as in increased costs, decreases in the amount of expected earnings and diversion of management’s time and energy and could adversely impact the Company’s business prospects, financial position and results of operations.
As of December 31, 2014, Radian Asset had an insured portfolio of $10 billion of statutory public finance net par outstanding and $8 billion of statutory structured finance net par outstanding. Since January 1, 2015, Radian Asset’s statutory structured finance net par outstanding has declined by $3.8 billion as a result of the termination of seven corporate collateralized debt obligation transactions. As of December 31, 2014, Radian Asset had approximately $1,138.9 million of statutory policyholders’ surplus and $189.1 million of contingency reserves.
Results of Operations
Estimates and Assumptions
The Company’s consolidated financial statements include amounts that are determined using estimates and assumptions. The actual amounts realized could ultimately be materially different from the amounts currently provided for in the Company’s consolidated financial statements. Management believes the most significant items requiring inherently subjective and complex estimates are expected losses, including assumptions for breaches of R&W, fair value estimates, other-than-temporary impairment, deferred income taxes, and premium revenue recognition. The following discussion of the results of operations includes information regarding the estimates and assumptions used for these items and should be read in conjunction with the notes to the Company’s consolidated financial statements.
An understanding of the Company’s accounting policies is of critical importance to understanding its consolidated financial statements. See Part II, Item 8. “Financial Statements and Supplementary Data” for a discussion of significant accounting policies, and fair value methodologies.
The Company carries a portion of its assets and liabilities at fair value, the majority of which are measured at fair value on a recurring basis. Level 3 assets, consisting primarily of financial guaranty variable interest entities’ assets, credit derivative assets and investments, represented approximately 18% and 25% of total assets measured at fair value on a recurring
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basis as of December 31, 2014 and 2013, respectively. All of the Company's liabilities that are measured at fair value are Level 3. See Note 8, Fair Value Measurement, of the Financial Statements and Supplementary Data for additional information about assets and liabilities classified as Level 3.
Consolidated Results of Operations
Consolidated Results of Operations
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Revenues: | |||||||||||
Net earned premiums | $ | 570 | $ | 752 | $ | 853 | |||||
Net investment income | 403 | 393 | 404 | ||||||||
Net realized investment gains (losses) | (60 | ) | 52 | 1 | |||||||
Net change in fair value of credit derivatives: | |||||||||||
Realized gains (losses) and other settlements | 23 | (42 | ) | (108 | ) | ||||||
Net unrealized gains (losses) | 800 | 107 | (477 | ) | |||||||
Net change in fair value of credit derivatives | 823 | 65 | (585 | ) | |||||||
Fair value gains (losses) on committed capital securities ("CCS") | (11 | ) | 10 | (18 | ) | ||||||
Fair value gains (losses) on FG VIEs | 255 | 346 | 191 | ||||||||
Other income (loss) | 14 | (10 | ) | 108 | |||||||
Total revenues | 1,994 | 1,608 | 954 | ||||||||
Expenses: | |||||||||||
Loss and loss adjustment expenses | 126 | 154 | 504 | ||||||||
Amortization of deferred acquisition costs | 25 | 12 | 14 | ||||||||
Interest expense | 92 | 82 | 92 | ||||||||
Other operating expenses | 220 | 218 | 212 | ||||||||
Total expenses | 463 | 466 | 822 | ||||||||
Income (loss) before provision for income taxes | 1,531 | 1,142 | 132 | ||||||||
Provision (benefit) for income taxes | 443 | 334 | 22 | ||||||||
Net income (loss) | $ | 1,088 | $ | 808 | $ | 110 | |||||
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Net Earned Premiums
Net earned premiums are recognized over the contractual lives, or in the case of homogeneous pools of insured obligations, the remaining expected lives, of financial guaranty insurance contracts. The Company estimates remaining expected lives of its insured obligations and makes prospective adjustments for such changes in expected lives.
Net Earned Premiums
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Financial guaranty: | |||||||||||
Public finance | |||||||||||
Scheduled net earned premiums and accretion | $ | 279 | $ | 292 | $ | 339 | |||||
Accelerations (1) | 135 | 207 | 250 | ||||||||
Total public finance | 414 | 499 | 589 | ||||||||
Structured finance (2) | |||||||||||
Scheduled net earned premiums and accretion | 152 | 195 | 263 | ||||||||
Accelerations (1) | 1 | 56 | — | ||||||||
Total structured finance | 153 | 251 | 263 | ||||||||
Other | 3 | 2 | 1 | ||||||||
Total net earned premiums | $ | 570 | $ | 752 | $ | 853 | |||||
____________________
(1) | Reflects the unscheduled refunding of an insured obligation or the termination of the insurance on an insured obligation. |
(2) | Excludes $32 million, $60 million and $153 million for 2014, 2013 and 2012, respectively, related to consolidated FG VIEs. |
2014 compared with 2013: Net earned premiums decreased compared with 2013 due primarily to lower accelerations and the scheduled decline in structured finance par outstanding, as shown in the table above. At December 31, 2014, $3.8 billion of net deferred premium revenue remained to be earned over the life of the insurance contracts.
2013 compared with 2012: Net earned premiums decreased compared with 2012 due primarily to the scheduled amortization of the insured portfolio offset in part by higher premium accelerations due to refundings and terminations. At December 31, 2013, $4.2 billion of net deferred premium revenue remained to be earned over the life of the insurance contracts.
Scheduled net earned premiums are expected to decrease each year unless replaced by a higher amount of new business or reassumptions of previously ceded business. See Note 4, Financial Guaranty Insurance Premiums, of the Financial Statements and Supplementary Data, for the expected timing of future premium earnings.
Net Investment Income
Net investment income is a function of the yield that the Company earns on invested assets and the size of the portfolio. The investment yield is a function of market interest rates at the time of investment as well as the type, credit quality and maturity of the invested assets.
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Net Investment Income (1)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Income from fixed-maturity securities managed by third parties | $ | 324 | $ | 322 | $ | 346 | |||||
Income from internally managed securities: | |||||||||||
Fixed-maturities | 74 | 74 | 60 | ||||||||
Other invested assets | 13 | 5 | 6 | ||||||||
Other | 1 | 0 | 1 | ||||||||
Gross investment income | 412 | 401 | 413 | ||||||||
Investment expenses | (9 | ) | (8 | ) | (9 | ) | |||||
Net investment income | $ | 403 | $ | 393 | $ | 404 | |||||
____________________
(1) | Net investment income excludes $11 million for 2014 and $13 million for 2013 and 2012, related to consolidated FG VIEs. |
2014 compared with 2013: Net investment income increased primarily due to income on certain loss mitigation and other risk management assets as well as higher average asset balance. The overall pre-tax book yield was 3.65% as of December 31, 2014 and 3.79% as of December 31, 2013, respectively. Excluding the internally managed portfolio, pre-tax yield was 3.36% as of December 31, 2014 compared with 3.42% as of December 31, 2013.
2013 compared with 2012: Net investment income decreased primarily due to lower reinvestment rates, partially offset by higher income earned on loss mitigation securities, which the Company generally purchased at a discount resulting in higher yields. The overall pre-tax book yield was 3.79% at December 31, 2013 and 3.85% at December 31, 2012, respectively. Excluding internally managed portfolio, pre-tax yield was 3.42% as of December 31, 2013 compared with 3.57% as of December 31, 2012.
Net Realized Investment Gains (Losses)
The table below presents the components of net realized investment gains (losses). See Note 11, Investments and Cash, of the Financial Statements and Supplementary Data.
Net Realized Investment Gains (Losses)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Gross realized gains on investment portfolio | $ | 22 | $ | 113 | $ | 43 | |||||
Gross realized losses on investment portfolio | (7 | ) | (19 | ) | (25 | ) | |||||
Other-than-temporary impairment | (75 | ) | (42 | ) | (17 | ) | |||||
Net realized investment gains (losses) (1) | $ | (60 | ) | $ | 52 | $ | 1 | ||||
____________________
(1) | Excludes realized gains (losses) related to consolidated FG VIEs of $5 million for 2014, $(2) million for 2013 and $(4) million for 2012. |
Other-than-temporary impairment for 2014 and 2013 was primarily attributable to securities in the internally managed portfolio received as part of a restructuring of an insured transaction. Realized gains for 2013 when compared to 2012 included sales of (i) assets acquired as part of negotiated settlements, (ii) bonds purchased for loss mitigation purposes and (iii) other invested assets.
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Other Income (Loss)
Other income (loss) is comprised of recurring items such as foreign exchange remeasurement gains and losses, ancillary fees on financial guaranty policies such as commitment, consent and processing fees, as well as other revenue items on financial guaranty insurance and reinsurance contracts such as commutation gains on re-assumptions of previously ceded business.
Other Income (Loss)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Foreign exchange gain (loss) on remeasurement of premium receivable and loss reserves | $ | (21 | ) | $ | (1 | ) | $ | 22 | |||
Commutation gains | 23 | 2 | 82 | ||||||||
Other | 12 | (11 | ) | 4 | |||||||
Total other income (loss) | $ | 14 | $ | (10 | ) | $ | 108 | ||||
Over the past several years the Company has entered into several commutations in order to reassume previously ceded books of business from its reinsurers that resulted in gains, as discussed in Note 14, Reinsurance and Other Monoline Exposures, of the Financial Statements and Supplementary Data.
In addition, Other income in 2014 was also impacted by changes in foreign exchange rates used to remeasure foreign denominated assets and liabilities.
Other Operating Expenses and Amortization of Deferred Acquisition Costs
2014 compared with 2013: Other operating expenses increased primarily due to higher employee compensation and severance expense, partially offset by the reduction in the credit facility fee with Dexia (see Note 17, Long-Term Debt and Credit Facilities, of the Financial Statements and Supplementary Data) and lower premium tax expense. In addition, amortization of deferred acquisition costs increased due primarily to certain premium accelerations.
2013 compared with 2012: Other operating expenses increased primarily due to higher employee compensation and benefits. In 2012, the employee compensation and benefits were impacted by the reduction of the bonus and Performance Retention Plan ("PRP") accruals.
Losses in the Insured Portfolio
The insured portfolio includes policies accounted for under three separate accounting models depending on the characteristics of the contract and the Company’s control rights. Please refer to Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data, for a discussion of the assumptions and methodologies used in calculating the expected loss to be paid for all contracts. For a discussion of the measurement and recognition accounting policies under GAAP for each type of contract, see the following in Item 8, Financial Statements and Supplementary Data:
•Notes 4, 5 and 7 for financial guaranty insurance,
•Note 9 for credit derivatives,
•Note 10 for consolidated FG VIE, and
•Note 8 for fair value methodologies for credit derivatives and FG VIE assets and liabilities.
The discussion of losses that follows encompasses losses on all contracts in the insured portfolio regardless of accounting model, unless otherwise specified. In order to effectively evaluate and manage the economics of the entire insured portfolio, management compiles and analyzes expected loss information for all policies on a consistent basis. That is, management monitors and assigns ratings and calculates expected losses in the same manner for all its exposures. Management also considers contract specific characteristics that affect the estimates of expected loss.
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The surveillance process for identifying transactions with expected losses is described in the notes to the consolidated financial statements. More extensive monitoring and intervention is employed for all BIG surveillance categories, with internal credit ratings reviewed quarterly.
Net expected loss to be paid consists primarily of the present value of future: expected claim payments, expected recoveries from excess spread and other collateral in the transaction structures, cessions to reinsurers, and expected recoveries for breaches of R&W and the effects of other loss mitigation strategies. Current risk free rates are used to discount expected losses at the end of each reporting period and therefore changes in such rates from period to period affect the expected loss estimates reported. The effect of changes in discount rates are included in net economic loss development, however, economic loss development attributable to changes in discount rates is not indicative of credit impairment or improvement. Assumptions used in the determination of the net expected loss to be paid such as delinquency, severity, and discount rates and expected timeframes to recovery in the mortgage market were consistent by sector regardless of the accounting model used. The primary drivers of changes in expected loss to be paid are discussed below.
The primary differences between net economic loss development and loss and LAE reported under GAAP are that GAAP (1) considers deferred premium revenue in the calculation of loss reserves and loss expense for financial guaranty insurance contracts, (2) eliminates losses related to FG VIEs and (3) does not include estimated losses on credit derivatives. Loss expense reported in operating income includes losses on credit derivatives and does not eliminate losses on FG VIEs. For financial guaranty insurance contracts, a loss is generally recorded only when expected losses exceed deferred premium revenue. Therefore, the timing of loss recognition does not necessarily coincide with the timing of the actual credit impairment or improvement reported in net economic loss development. AGM's U.S. RMBS transactions generally have the largest deferred premium revenue balances because of the purchase accounting adjustments that were made in 2009 in connection with Assured Guaranty's purchase of AGM, and therefore the largest differences between net economic loss development and loss expense relate to AGM policies. See "–Losses Incurred" below.
Economic Loss Development (Benefit) (1)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
U.S. RMBS before benefit for recoveries for breaches of R&W | $ | 0 | $ | 140 | $ | 367 | |||||
Net benefit for recoveries for breaches of R&W | (268 | ) | (296 | ) | (179 | ) | |||||
U.S. RMBS after benefit for recoveries for breaches of R&W | (268 | ) | (156 | ) | 188 | ||||||
Other structured finance | 68 | (34 | ) | (28 | ) | ||||||
Public finance | 171 | 256 | 295 | ||||||||
Other | (1 | ) | (10 | ) | (17 | ) | |||||
Total | $ | (30 | ) | $ | 56 | $ | 438 | ||||
____________________
(1) | Economic loss development includes the effects of changes in assumptions based on observed market trends, changes in discount rates, accretion of discount and the economic effects of loss mitigation efforts. |
Net Expected Loss to be Paid
As of December 31, 2014 | As of December 31, 2013 | ||||||
(in millions) | |||||||
U.S. RMBS before benefit for recoveries for breaches of R&W | $ | 901 | $ | 1,205 | |||
Net benefit for recoveries for breaches of R&W | (317 | ) | (712 | ) | |||
U.S. RMBS after benefit for recoveries for breaches of R&W | 584 | 493 | |||||
Other structured finance | 241 | 171 | |||||
Public finance | 348 | 321 | |||||
Other | (4 | ) | (3 | ) | |||
Total | $ | 1,169 | $ | 982 | |||
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2014 Net Economic Loss Development
Total economic loss development was a favorable $30 million in 2014, due primarily to the various U.S. RMBS R&W settlements during the year and improvements in some of the Company's insured TruPS transactions. This was partially offset by U.S. public finance losses related to Puerto Rico and Detroit and structured finance losses that resulted primarily from changes in underlying assumptions on life insurance securitization transactions and the decrease in discount rates used. The risk-free rates used to discount expected losses ranged from 0.0% to 2.95% as of December 31, 2014 compared with 0.0% to 4.44% as of December 31, 2013.
U.S. Public Finance Economic Loss Development: The net par outstanding for U.S. public finance obligations rated BIG by the Company was $7.9 billion as of December 31, 2014 compared with $9.1 billion as of December 31, 2013. The Company projects that its total net expected loss across its troubled U.S. public finance credits as of December 31, 2014 will be $303 million, compared with $264 million as of December 31, 2013. Economic loss development in 2014 was approximately $183 million, which was primarily attributable to Puerto Rico and Detroit exposures. See "Insured Portfolio-Exposure to Puerto Rico" below for details about significant developments that have taken place in Puerto Rico over the course of 2014.
U.S. RMBS Economic Loss Development: The net benefit attributable to U.S. RMBS of $268 million was primarily due to the R&W settlements during the year. Please refer to Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data, for additional information.
Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology to project first lien RMBS losses as of December 31, 2014 as it used as of December 31, 2013, but it made a number of refinements to reflect its observations, notably:
• | updated the liquidation rates it uses on delinquent loans based on observations and on an assumption that loan modifications (which improve liquidation rates) would over the next year be less frequent than they were over the most recent year |
• | updated the liquidation rate it uses for loans reported as current but that had been reported as modified over the previous twelve months, based on observations |
• | established a liquidation rate assumption for loans reported as current and not modified in the past twelve months but that had been reported as delinquent in the previous twelve months |
• | established loss severity assumptions by vintage category as well as product type, rather than just product type as previously |
• | beginning with the third quarter 2014, each quarter shortened by three months the period it is projecting it will take in the base case to reach the final conditional default rate ("CDR") |
The methodology and revised assumptions the Company uses to project first lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. First Lien RMBS Loss Projections: Alt A First Lien, Option ARM, Subprime and Prime". The Company estimated the impact of all of the refinements to its first lien RMBS assumptions described above to be a decrease of expected losses of approximately $42 million (before adjustments for settlements or loss mitigation purchases) by projecting losses on the first lien RMBS portfolio as of December 31, 2014 using base case assumptions similar to what it used as of December 31, 2013 and comparing those results to those results from the refined assumptions. Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology to project second lien RMBS losses as of December 31, 2014 as it used as of December 31, 2013, but it made a number of refinements to reflect its observations, notably with respect to most home equity lines of credit ("HELOC") projections to:
• | reflect increased recoveries on newly defaulted loans as well as previously defaulted loans |
• | project incremental defaults associated with increased monthly payments that occur when interest-only periods end |
• | increase the assumed final conditional prepayment rate from 10% to 15% |
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The methodology and assumptions the Company uses to project second lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien".
Generally, when mortgage loans are transferred into a securitization, the loan originator(s) and/or sponsor(s) provide R&W that the loans meet certain characteristics, and a breach of such R&W often requires that the loan be repurchased from the securitization. In many of the transactions the Company insures, it is in a position to enforce these R&W provisions. Through December 31, 2014 the Company has caused entities providing R&Ws to pay, or agree to pay, or to terminate insurance protection on future projected losses of, approximately $4.2 billion (gross of reinsurance) in respect of their R&W liabilities for transactions in which the Company has provided insurance.
Based on this success, the Company has included in its net expected loss estimates as of December 31, 2014 an estimated net benefit related to breaches of R&W of $317 million, net of reinsurance.
Developments in the Company's R&W recovery efforts are included in economic loss development and relate primarily to settlements during the period.
Infrastructure: The Company has insured exposure of approximately $3.0 billion to infrastructure transactions with refinancing risk as to which the Company may need to make claim payments that it did not anticipate paying when the policies were issued. For more information about this risk, see the Risk Factor captioned "Estimates of expected losses are subject to uncertainties and may not be adequate to cover potential paid claims" under Risks Related to the Company's Expected Losses in "Item 1A. Risk Factors."
2013 Net Economic Loss Development
Total economic loss development was $56 million in 2013, primarily due to U.S. public finance losses related to Detroit, Puerto Rico and Harrisburg, partially offset by favorable development in U.S. RMBS due to the various settlements during the year. Excluding the settlements, U.S. RMBS loss development was primarily due to the change in assumptions for first liens. The risk-free rates used to discount expected losses ranged from 0.0%to 4.44% as of December 31, 2013 compared with 0.0% to 3.28% as of December 31, 2012.
U.S. Public Finance Economic Loss Development: The Company insured general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $5.4 billion net par as of December 31, 2013. The Company rated $5.2 billion net par of that amount BIG. Debt obligations of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations came under increasing pressure during 2013 and in February 2014, S&P, Moody's and Fitch Ratings downgraded much of the debt of Puerto Rico and its related authorities and public corporations to BIG.
Many U.S. municipalities and related entities continued to be under increased pressure in 2013, and a few had filed for protection under the U.S. Bankruptcy Code, entered into state processes designed to help municipalities in fiscal distress or otherwise indicated they may consider not meeting their obligations to make timely payments on their debts. The municipalities whose obligations the Company had insured that had filed for protection under Chapter 9 of the U.S Bankruptcy Code were: Detroit, Michigan; Jefferson County, Alabama; and Stockton, California. The City Council of Harrisburg, Pennsylvania had also filed a purported bankruptcy petition, which was later dismissed by the bankruptcy court; a receiver for the City of Harrisburg was appointed by the Commonwealth Court of Pennsylvania on December 2, 2011. In 2013, the Company reached agreements with Jefferson County, Harrisburg and Stockton.
The net par outstanding for these and all other BIG rated U.S. public finance obligations was $9.1 billion as of December 31, 2013. The Company projected that its total future expected net loss across its troubled U.S. public finance credits as of December 31, 2013 was $264 million, up from $7 million as of December 31, 2012. The net increase of $257 million in expected loss was primarily attributable to deterioration in the credit of Puerto Rico and its related authorities and public corporations, the bankruptcy filing by the City of Detroit, and a final resolution in Harrisburg that was somewhat worse for the Company than it projected as of December 31, 2012, offset in part primarily by the final resolution of the Company's Jefferson County exposure.
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U.S. RMBS Economic Loss Development
Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general approach (with the refinements described below) to project RMBS losses as of December 31, 2013 as it used as of December 31, 2012. The Company's use of the same general methodology to project RMBS losses as of December 31, 2013 as it used as of December 31, 2012 was consistent with its view at December 31, 2013 that the housing and mortgage market recovery was occurring at a slower pace than it anticipated at December 31, 2012.
The Company refined its first lien RMBS loss projection methodology as of December 31, 2013 to model explicitly the behavior of borrowers with loans that had been modified. The Company had observed that mortgage loan servicers were modifying more mortgage loans (reducing or forbearing from collecting interest or principal or both due on mortgage loans) to reduce the borrowers’ monthly payments and so improve their payment performance than was the case before the mortgage crisis. Borrowers who are current based on their new, reduced monthly payments are generally reported as current, but are more likely to default than borrowers who are current and whose loans have not been modified. The Company believed modified loans are most likely to default again during the first year after modification. The Company set its liquidation rate assumptions as of December 31, 2012 based on observed roll rates and with modification activity in mind. As of December 31, 2013 the Company made a number of refinements to its first lien RMBS loss projection assumptions to treat loan modifications explicitly. Specifically, in the base case approach, it:
• | established a liquidation rate assumption for loans reported as current but that had been reported as modified in the previous 12 months, |
• | assumed that currently delinquent loans that did not roll to liquidation would behave like modified loans, and so applied the modified loan liquidation rate to them, |
• | increased from two to three years the period over which it calculates the initial CDR based on assumed liquidations of non-performing loans and modified loans, to account for the longer period modified loans will take to default, |
• | increased the period it assumes the transactions will experience the initial loss severity assumption before it improves and the period during which the transaction will experience low voluntary prepayment rates, |
• | established an assumption for servicers not to advance loan payments on all delinquent loans |
The methodology and revised assumptions the Company used to project first lien RMBS losses and the scenarios it employed are described in more detail Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data. The refinement in assumptions described above resulted in a reduction of the initial CDRs but the application of the initial CDRs for a longer period generally resulted in a higher amount of loans being liquidated at the initial CDR under the refined assumptions than under the initial CDR under the previous assumptions. The Company estimated the impact of all of the refinements to its assumptions described above to be an increase of expected losses of approximately $8 million (before adjustments for settlements or loss mitigation purchases) by running on the first lien RMBS portfolio as of December 31, 2013 base case assumptions similar to what it used as of December 31, 2012 and comparing those results to the results from the refined assumptions.
During 2013 the Company observed improvements in the performance of its second lien RMBS transactions that, when viewed in the context of their performance prior to 2013, suggested those transactions were beginning to respond to the improvements in the residential property market and economy being widely reported by market observers. Based on such observations, in projecting losses for second lien RMBS the Company chose to decrease by two months in its base scenario and by three months in its optimistic scenario the period it assumed it would take the mortgage market to recover as compared to December 31, 2012. Also during 2013 the Company observed material improvements in the delinquency measures of certain second lien RMBS for which the servicing had been transferred, and made certain adjustments on just those transactions to reflect its view that much of this improvement was due to loan modifications and reinstatements made by the new servicer and that such recently modified and reinstated loans may have a higher likelihood of defaulting again.
Developments in the Company's R&W recovery efforts are included in economic loss development. R&W development in 2013 was primarily attributable to settlements and anticipated settlements.
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2012 Net Economic Loss Development
Total economic loss development in 2012 was $438 million, which was primarily driven by losses on the Company's troubled European exposures, particularly a $189 million loss in relation to the Company's Greek sovereign bond exposures and loss development on Spanish sub-sovereign exposures, higher U.S. RMBS and U.S. public finance losses, offset in part by positive developments in the TruPS portfolio. Changes in discount rates did not have a significant effect on economic loss development in 2012 as the risk-free rates used to discount expected losses ranged from 0.0% to 3.28% as of December 31, 2012 compared with 0.0% to 3.27% as of December 31, 2011.
Based on the Company’s observation during 2012 of the performance of its insured RMBS transactions (including early stage delinquencies, late stage delinquencies and, for first liens, loss severity) as well as the residential property market and economy in general, the Company chose to use essentially the same assumptions and scenarios to project RMBS loss as of December 31, 2012 as it used as of December 31, 2011, except that as compared to December 31, 2011:
• | in its most optimistic scenario, it reduced by three months the period it assumed it would take the mortgage market to recover; and |
• | in its most pessimistic scenario, it increased by three months the period it assumed it would take the mortgage market to recover. |
The Company's use of essentially the same assumptions and scenarios to project RMBS losses as of December 31, 2012 and December 31, 2011 was consistent with its view at December 31, 2012 that the housing and mortgage market recovery was occurring at a slower pace than it anticipated at December 31, 2011. The Company's changes during 2012 to the period it would take the mortgage market to recover in its most optimistic scenario and its most pessimistic scenario allowed it to consider a wider range of possibilities for the speed of the recovery. Since the Company's projections for each RMBS transaction are based on the delinquency performance of the loans in that individual RMBS transaction, improvement or deterioration in that aspect of a transaction's performance impacts the projections for that transaction. The methodology the Company used to project RMBS losses and the scenarios it employs are described in more detail in Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data.
Developments in the Company's R&W recovery efforts are also included in economic loss development. R&W development in 2012 was primarily attributable to settlements and judgments and increases in projected defaults that result in increased projected reimbursements under existing R&W agreements.
Losses Incurred
For transactions accounted for as financial guaranty insurance under GAAP, each transaction’s expected loss to be expensed, net of estimated R&W recoveries, is compared with the deferred premium revenue of that transaction. Generally, when the expected loss to be expensed exceeds the deferred premium revenue, a loss is recognized in the income statement for the amount of such excess.
When the Company measures operating income, a non-GAAP financial measure, it calculates the credit derivative and FG VIE losses incurred in a similar manner. Changes in fair value in excess of expected loss that are not indicative of economic deterioration or improvement are not included in operating income.
Expected loss to be paid, as discussed above under "Losses in the Insured Portfolio," is an important liquidity measure in that it provides the present value of amounts that the Company expects to pay or recover in future periods. Expected loss to be expensed is important because it presents the Company’s projection of incurred losses that will be recognized in future periods as deferred premium revenue amortizes into income on financial guaranty insurance policies. Expected loss to be paid for FG VIEs pursuant to AGC’s and AGM’s financial guaranty policies is calculated in a manner consistent with financial guaranty insurance contracts, but eliminated in consolidation under GAAP.
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The following tables present the loss and LAE recorded in the consolidated statements of operations by sector for non-derivative contracts and the loss expense recorded under non-GAAP operating income, respectively. Amounts presented are net of reinsurance. Changes in risk free rates used to discount losses affect both economic development and loss expense, however the effect of changes in discount rates are not indicative of actual credit impairment or improvement in the period.
Loss and LAE Reported
on the Consolidated Statements of Operations
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
U.S. RMBS | $ | (129 | ) | $ | (4 | ) | $ | 308 | |||
Other structured finance | 95 | (35 | ) | (7 | ) | ||||||
Public finance | 191 | 214 | 285 | ||||||||
Other | (1 | ) | — | (17 | ) | ||||||
Total insurance contracts before FG VIE consolidation | 156 | 175 | 569 | ||||||||
Effect of consolidating FG VIEs | (30 | ) | (21 | ) | (65 | ) | |||||
Total loss and LAE | $ | 126 | $ | 154 | $ | 504 | |||||
Loss Expense Reported in
Non-GAAP Operating Income
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
U.S. RMBS | $ | (184 | ) | $ | 8 | $ | 369 | ||||
Other structured finance | 76 | (36 | ) | (40 | ) | ||||||
Public finance | 188 | 212 | 284 | ||||||||
Other | (1 | ) | (10 | ) | (17 | ) | |||||
Total | $ | 79 | $ | 174 | $ | 596 | |||||
Reconciliation of Loss and LAE to Non-GAAP Loss Expense
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Loss and LAE | $ | 126 | $ | 154 | $ | 504 | |||||
Credit derivative loss expense | (77 | ) | (1 | ) | 28 | ||||||
FG VIE loss expense | 30 | 21 | 64 | ||||||||
Loss expense included in operating income | $ | 79 | $ | 174 | $ | 596 | |||||
In 2014, losses incurred were due primarily to U.S. public finance, including Puerto Rico and Detroit, and structured finance, primarily "XXX" life insurance transactions, partially offset by a U.S. RMBS benefit and improvements in some of the Company's insured TruPS transactions. The positive developments in U.S. RMBS were due primarily to the settlement of several R&W claims. Changes in risk-free rates used to discount losses also adversely affected loss expense for long-dated transactions, however this component of loss expense does not reflect actual credit impairment or improvement in the period.
In 2013, losses incurred were due primarily to U.S. public finance, including Detroit, Puerto Rico and Harrisburg partially offset by positive developments in structured finance, primarily "XXX" life insurance transactions and U.S. RMBS. The positive developments in U.S. RMBS were primarily due to the settlement of several R&W claims. Changes in risk-free
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rates used to discount losses also affected loss expense for long-dated transactions, however this component of loss expense does not reflect actual credit impairment or improvement in the period.
In 2012, U.S. RMBS insured transactions generated the majority of the losses, partially offset by R&W recoveries and negotiated loss sharing agreements. The incurred loss in public finance in 2012 was primarily due to the Company's Greek sovereign exposures.
For financial guaranty contracts accounted for as insurance, the amounts reported in the GAAP financial statements may only reflect a portion of the current period’s economic development and may also include a portion of prior-period economic development. The difference between economic loss development on financial guaranty insurance contracts and loss and LAE recognized in GAAP income is essentially loss development and accretion for financial guaranty insurance contracts that is, or was previously, absorbed in unearned premium reserve, which have not yet been recognized in income.
The table below presents the expected timing of loss recognition for insurance contracts on both a reported GAAP net income and non-GAAP operating income basis.
Financial Guaranty Insurance
Net Expected Loss to be Expensed
As of December 31, 2014
In GAAP Reported Income | In Non-GAAP Operating Income | ||||||
(in millions) | |||||||
2015 | $ | 33 | $ | 45 | |||
2016 | 34 | 44 | |||||
2017 | 27 | 36 | |||||
2018 | 24 | 31 | |||||
2019 | 22 | 28 | |||||
2020-2024 | 79 | 100 | |||||
2025-2029 | 46 | 55 | |||||
2030-2034 | 32 | 41 | |||||
After 2034 | 21 | 27 | |||||
Net expected loss to be expensed (1) | 318 | 407 | |||||
Discount | 413 | 447 | |||||
Total future value | $ | 731 | $ | 854 | |||
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(1) | Net expected loss to be expensed for GAAP reported income is different than operating income, a non-GAAP financial measure, by the amount related to consolidated FG VIEs. |
Net Change in Fair Value of Credit Derivatives
Changes in the fair value of credit derivatives occur primarily because of changes in interest rates, credit spreads, notional amounts, credit ratings of the referenced entities, expected terms, realized gains (losses) and other settlements, and the issuing company's own credit rating and credit spreads, and other market factors. With considerable volatility continuing in the market, unrealized gains (losses) on credit derivatives may fluctuate significantly in future periods.
Except for net estimated credit impairments (i.e., net expected payments), the unrealized gains and losses on credit derivatives are expected to reduce to zero as the exposure approaches its maturity date. Changes in the fair value of the Company’s credit derivatives that do not reflect actual or expected claims or credit losses have no impact on the Company’s statutory claims-paying resources, rating agency capital or regulatory capital positions. Expected losses to be paid in respect of contracts accounted for as credit derivatives are included in the discussion above “—Losses in the Insured Portfolio.”
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative
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contracts also reflects the change in the Company’s own credit cost based on the price to purchase credit protection on AGC and AGM. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date. Generally, a widening of the CDS prices traded on AGC and AGM has an effect of offsetting unrealized losses that result from widening general market credit spreads, while a narrowing of the CDS prices traded on AGC and AGM has an effect of offsetting unrealized gains that result from narrowing general market credit spreads.
The valuation of the Company’s credit derivative contracts requires the use of models that contain significant, unobservable inputs, and are classified as Level 3 in the fair value hierarchy. The models used to determine fair value are primarily developed internally based on market conventions for similar transactions that the Company observed in the past. There has been very limited new issuance activity in this market over the past three years and as of December 31, 2014, market prices for the Company’s credit derivative contracts were generally not available. Inputs to the estimate of fair value include various market indices, credit spreads, the Company’s own credit spread, and estimated contractual payments. See Note 8, Fair Value Measurement, of the Financial Statements and Supplemental Data.
The fair value of the Company's credit derivative contracts represents the difference between the present value of remaining net premiums the Company expects to receive or pay for the credit protection under the contract and the estimated present value of premiums that a financial guarantor of comparable credit-worthiness would hypothetically charge or pay the Company for the same protection. The fair value of the Company's credit derivatives depends on a number of factors including notional amount of the contract, expected term, credit spreads, interest rates, the credit ratings of referenced entities, the Company’s own credit risk and remaining contractual cash flows.
Management considers the non-standard terms of its credit derivative contracts in determining the fair value of these contracts. These terms differ from more standardized credit derivatives sold by companies outside of the financial guaranty industry. The non-standard terms include the absence of collateral support agreements or immediate settlement provisions. In addition, the Company employs relatively high attachment points. Because of these terms and conditions, the fair value of the Company’s credit derivatives may not reflect the same prices observed in an actively traded market of CDS that do not contain terms and conditions similar to those observed in the financial guaranty market. The Company considers R&W claim recoveries in determining the fair value of its CDS contracts.
Management considers factors such as current prices charged for similar agreements when available, performance of underlying assets, life of the instrument and the nature and extent of activity in the financial guaranty credit derivative marketplace. The assumptions that management uses to determine the fair value may change in the future due to market conditions. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these credit derivative products, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements and the differences may be material.
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Net Change in Fair Value of Credit Derivatives
Gain (Loss)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Realized gains on credit derivatives (credit derivative revenues) | $ | 73 | $ | 121 | $ | 128 | |||||
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements | (50 | ) | (163 | ) | (236 | ) | |||||
Realized gains (losses) and other settlements on credit derivatives | 23 | (42 | ) | (108 | ) | ||||||
Net change in unrealized gains (losses) on credit derivatives: | |||||||||||
Pooled corporate obligations | (18 | ) | (32 | ) | 59 | ||||||
U.S. RMBS | 814 | (69 | ) | (551 | ) | ||||||
CMBS | 2 | — | 2 | ||||||||
Other(1) | 2 | 208 | 13 | ||||||||
Net change in unrealized gains (losses) on credit derivatives | 800 | 107 | (477 | ) | |||||||
Net change in fair value of credit derivatives | $ | 823 | $ | 65 | $ | (585 | ) | ||||
____________________
(1) | “Other” includes all other U.S. and international asset classes, such as commercial receivables, international infrastructure, international RMBS securities, and pooled infrastructure securities. |
Net credit derivative premiums have declined in 2014 and 2013 due primarily to the decline in the net par outstanding to $35.0 billion at December 31, 2014 from $54.5 billion at December 31, 2013 and $70.8 billion at December 31, 2012.
The table below sets out the net par amount of credit derivative contracts that the Company and its counterparties agreed to terminate on a consensual basis.
Net Par and Realized gains (losses) on Credit Derivatives
from Terminations of CDS Contracts
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Net par of terminated CDS contracts | $ | 3,591 | $ | 4,054 | $ | 2,264 | |||||
Realized gains (losses) and other settlements | 1 | 21 | 3 | ||||||||
During 2014, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien, Option ARM and subprime sectors. This is primarily due to a significant unrealized fair value gain in the Option ARM and Alt-A first lien sector of approximately $543 million, as a result of the terminations of three large Alt-A first lien resecuritization transactions and one Option ARM first lien transaction during the period. In addition, there was an unrealized gain of approximately $346 million related to the Company’s refinement of pricing assumptions during the fourth quarter of 2014. In the fourth quarter of 2014, new market indices were published on Option ARM and Alt-A first lien securitizations. As part of the Company’s normal review process the Company reviewed these indices and based upon the collateral make-up, collateral vintage, and collateral loss experience, determined it to be a better market indication for the Company’s Option ARM and Alt-A first lien securitizations. The unrealized fair value gains were partially offset by unrealized fair value losses generated by wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, as the market cost of AGC's and AGM’s credit protection decreased during the period. These transactions were pricing at or above their floor levels (or the minimum rate at which the Company would consider assuming these risks based on historical experience); therefore when the cost of purchasing CDS protection on AGC and AGM, which management refers to as the CDS spread on AGC and AGM, decreased the implied spreads that the Company would expect to receive on these transactions increased.
During 2013, unrealized fair value gains were generated in the “other” sector primarily as a result of the termination of a film securitization transaction and a U.K. infrastructure transaction, as well as price improvement on a XXX life
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securitization transaction. These unrealized gains were partially offset by unrealized fair value losses in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection decreased. These transactions were pricing above their floor levels; therefore when the cost of purchasing CDS protection on AGC, decreased the implied spreads that the Company would expect to receive on these transactions increased. The cost of AGM’s credit protection also decreased slightly during 2013, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels. The company terminated a film securitization CDS for a payment of $120 million which was recorded in realized gains (losses) and other settlements on credit derivatives, with a corresponding release of the unrealized loss recorded in unrealized gains (losses) on credit derivatives of $127 million for a net change in fair value of credit derivatives of $7 million.
During 2012, U.S. RMBS unrealized fair value losses were generated primarily in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors primarily as a result of the decreased cost to buy protection in AGC's name as the market cost of AGC's credit protection decreased. These transactions were pricing above their floor levels therefore when the cost of purchasing CDS protection on AGC decreased, the implied spreads that the Company would expect to receive on these transactions increased. The cost of AGM's credit protection also decreased during 2012, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels. In addition, 2012 included an $85 million unrealized gain relating to R&W benefits from the agreement with Deutsche Bank.
Five-Year CDS Spread
on AGC and AGM
Quoted price of CDS contract (in basis points)
As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | ||||||
AGC | 323 | 460 | 678 | |||||
AGM | 325 | 525 | 536 | |||||
One-Year CDS Spread
on AGC and AGM
Quoted price of CDS contract (in basis points)
As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | ||||||
AGC | 80 | 185 | 270 | |||||
AGM | 85 | 220 | 257 | |||||
Effect of Changes in the Company’s Credit Spread on
Unrealized Gains (Losses) on Credit Derivatives
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Change in unrealized gains (losses) of credit derivatives: | |||||||||||
Before considering implication of the Company’s credit spreads | $ | 1,396 | $ | 1,374 | $ | 798 | |||||
Resulting from change in the Company’s credit spreads | (596 | ) | (1,267 | ) | (1,275 | ) | |||||
After considering implication of the Company’s credit spreads | $ | 800 | $ | 107 | $ | (477 | ) | ||||
Management believes that the trading level of AGC’s and AGM’s credit spreads is due to the correlation between AGC’s and AGM’s risk profile, the current risk profile of the broader financial markets, and to increased demand for credit protection against AGC and AGM as the result of its financial guaranty volume, as well as the overall lack of liquidity in the CDS market. Offsetting the benefit attributable to AGC’s and AGM’s credit spread were higher credit spreads in the fixed
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income security markets relative to pre-financial crisis levels. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the high-yield CDO, trust preferred securities CDO ("TruPS CDOs"), and collateralized loan obligation ("CLO") markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.
Interest Expense
For the years ended December 31, 2014 and December 31, 2013, interest expense increased due to the issuance in June 2014 of 5.0% Senior Notes due 2024. For the years ended December 31, 2013 and December 31, 2012, interest expense decreased due to the retirement of the AGUS 8.5% Senior Notes on June 1, 2012. See Note 17, Long-Term Debt and Credit Facilities, of the Financial Statements and Supplementary Data. The following table presents the components of interest expense.
Interest Expense
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Debt issued by AGUS | $ | 36 | $ | 23 | $ | 31 | |||||
Debt issued by AGMH | 54 | 54 | 54 | ||||||||
Notes payable by AGM | 2 | 5 | 7 | ||||||||
Total | $ | 92 | $ | 82 | $ | 92 | |||||
Provision for Income Tax
Deferred income tax assets and liabilities are established for the temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities using enacted rates in effect for the year in which the differences are expected to reverse. Such temporary differences relate principally to unrealized gains and losses on investments and credit derivatives, FG VIE fair value adjustments, loss and LAE reserve, unearned premium reserve and tax attributes for net operating losses, alternative minimum tax credits and foreign tax credits. As of December 31, 2014 and December 31, 2013, the Company had a net deferred income tax asset of $260 million and $688 million, respectively. As of December 31, 2014, the Company had alternative minimum tax credits of 57 million which do not expire.
Provision for Income Taxes and Effective Tax Rates
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Total provision (benefit) for income taxes | $ | 443 | $ | 334 | $ | 22 | |||||
Effective tax rate | 28.9 | % | 29.2 | % | 16.5 | % | |||||
The Company’s effective tax rates reflect the proportion of income recognized by each of the Company’s operating subsidiaries, with U.S. subsidiaries taxed at the U.S. marginal corporate income tax rate of 35%, U.K. subsidiaries taxed at the U.K. blended marginal corporate tax rate of 21.5% unless subject to U.S. tax by election or as a U.S. controlled foreign corporation, and no taxes for the Company’s Bermuda subsidiaries unless subject to U.S tax by election or as a U.S. controlled foreign corporation. The Company’s overall corporate effective tax rate fluctuates based on the distribution of taxable income across these jurisdictions. In each of the periods presented, the portion of taxable income from each jurisdiction varied. 2013 and 2012 had disproportionate losses and income across jurisdictions, offset by tax-exempt interest, and are the primary reasons for the 29.2% and 16.5% effective tax rates, respectively. See Note 13, Income Taxes, of the Financial Statements and Supplementary Data for more details.
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Financial Guaranty Variable Interest Entities
As of December 31, 2014 and 2013, the Company consolidated 32 and 40 VIEs, respectively. The table below presents the effects on reported GAAP income resulting from consolidating these FG VIEs and eliminating their related insurance and investment accounts and, in total, represents a difference between GAAP reported net income and non-GAAP operating income attributable to FG VIEs. The consolidation of FG VIEs has a significant effect on net income and shareholders' equity due to (1) changes in fair value gains (losses) on FG VIE assets and liabilities, (2) the eliminations of premiums and losses related to the AGC and AGM FG VIE liabilities with recourse and (3) the elimination of investment balances related to the Company’s purchase of AGC and AGM insured FG VIE debt. Upon consolidation of a FG VIE, the related insurance and, if applicable, the related investment balances, are considered intercompany transactions and therefore eliminated. See “—Non-GAAP Financial Measures—Operating Income” below and Note 10, Consolidated Variable Interest Entities, of the Financial Statements and Supplementary Data for more details.
Effect of Consolidating FG VIEs on Net Income (Loss)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Net earned premiums | $ | (32 | ) | $ | (60 | ) | $ | (153 | ) | ||
Net investment income | (11 | ) | (13 | ) | (13 | ) | |||||
Net realized investment gains (losses) | (5 | ) | 2 | 4 | |||||||
Fair value gains (losses) on FG VIEs | 255 | 346 | 191 | ||||||||
Other income | (2 | ) | — | — | |||||||
Loss and LAE | 30 | 21 | 65 | ||||||||
Effect on net income before tax | 235 | 296 | 94 | ||||||||
Less: tax provision (benefit) | 82 | 103 | 32 | ||||||||
Effect on net income (loss) | $ | 153 | $ | 193 | $ | 62 | |||||
Fair value gains (losses) on FG VIEs represent the net change in fair value on the consolidated FG VIEs’ assets and liabilities. In 2014, the Company recorded a pre-tax net fair value gain on consolidated FG VIEs of $255 million. The primary driver of this gain, $120 million, was a result of the deconsolidation of seven VIEs. In addition, there was a gain of $37 million resulting from the Company exercising its option to accelerate two second lien RMBS bonds. The remainder of the gain for the period was driven by the price appreciation on the Company's FG VIE assets during the year resulting from improvements in the underlying collateral, as well as large principal paydowns made on the Company's FG VIEs.
In 2013, the Company recorded a pre-tax net fair value gain of consolidated FG VIEs of $346 million. The gain was primarily driven by R&W benefits received on several VIE assets as a result of settlements with various counterparties throughout the year. These R&W settlements resulted in a gain of approximately $265 million. The remainder of the gain was driven by price appreciation on the Company's FG VIE assets during the year resulting from improvements in the underlying collateral, as well as large principal paydowns made on the Company's FG VIEs.
In 2012, the Company recorded a pre-tax fair value gain on FG VIEs of $191 million. The majority of this gain, approximately $166 million, is a result of a R&W benefit received on several VIE assets as a result of a settlement with Deutsche Bank that closed in 2012. While prices continued to appreciate during the period on the Company's FG VIE assets and liabilities, gains in the year were primarily driven by large principal paydowns made on the Company's FG VIEs.
Expected losses to be paid (recovered) in respect of consolidated FG VIEs were $126 million of expected loss to be paid as December 31, 2014, and $60 million of expected losses to be paid as of December 31, 2013, are included in the discussion of “—Losses in the Insured Portfolio.”
Non-GAAP Financial Measures
To reflect the key financial measures management analyzes in evaluating the Company’s operations and progress towards long-term goals, the Company discusses both measures determined in accordance with GAAP and measures not promulgated in accordance with GAAP (“non-GAAP financial measures”). Although the financial measures identified as non-GAAP should not be considered substitutes for GAAP measures, management considers them key performance indicators and
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employs them as well as other factors in determining compensation. Non-GAAP financial measures, therefore, provide investors with important information about the key financial measures management utilizes in measuring its business. The primary limitation of non-GAAP financial measures is the potential lack of comparability to those of other companies, which may define non-GAAP measures differently because there is limited literature with respect to such measures. Three of the primary non-GAAP financial measures analyzed by the Company’s senior management are: operating income, adjusted book value and PVP.
Management and the board of directors utilize non-GAAP financial measures in evaluating the Company’s financial performance and as a basis for determining senior management incentive compensation. By providing these non-GAAP financial measures, investors, analysts and financial news reporters have access to the same information that management reviews internally. In addition, Assured Guaranty’s presentation of non-GAAP financial measures is consistent with how analysts calculate their estimates of Assured Guaranty’s financial results in their research reports on Assured Guaranty and with how investors, analysts and the financial news media evaluate Assured Guaranty’s financial results.
The following paragraphs define each non-GAAP financial measure and describe why it is useful. A reconciliation of the non-GAAP financial measure and the most directly comparable GAAP financial measure, is also presented below.
Operating Income
Reconciliation of Net Income (Loss)
to Operating Income
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
Net income (loss) | $ | 1,088 | $ | 808 | $ | 110 | |||||
Less after-tax adjustments: | |||||||||||
Realized gains (losses) on investments | (34 | ) | 40 | (4 | ) | ||||||
Non-credit impairment unrealized fair value gains (losses) on credit derivatives | 500 | (40 | ) | (486 | ) | ||||||
Fair value gains (losses) on CCS | (7 | ) | 7 | (12 | ) | ||||||
Foreign exchange gains (losses) on remeasurement of premiums receivable and loss and LAE reserves | (15 | ) | (1 | ) | 15 | ||||||
Effect of consolidating FG VIEs | 153 | 193 | 62 | ||||||||
Operating income | $ | 491 | $ | 609 | $ | 535 | |||||
Effective tax rate on operating income | 29.0 | % | 26.7 | % | 25.0 | % | |||||
Management believes that operating income is a useful measure because it clarifies the understanding of the underwriting results of the Company’s financial guaranty business, and also includes financing costs and net investment income, and enables investors and analysts to evaluate the Company’s financial results as compared with the consensus analyst estimates distributed publicly by financial databases. Operating income is defined as net income (loss) attributable to AGL, as reported under GAAP, adjusted for the following:
1) Elimination of the after-tax realized gains (losses) on the Company’s investments, except for gains and losses on securities classified as trading. The timing of realized gains and losses, which depends largely on market credit cycles, can vary considerably across periods. The timing of sales is largely subject to the Company’s discretion and influenced by market opportunities, as well as the Company’s tax and capital profile. Trends in the underlying profitability of the Company’s business can be more clearly identified without the fluctuating effects of these transactions.
2) Elimination of the after-tax non-credit impairment unrealized fair value gains (losses) on credit derivatives, which is the amount in excess of the present value of the expected estimated economic credit losses, and non-economic payments. Such fair value adjustments are heavily affected by, and in part fluctuate with, changes in market interest rates, credit spreads and other market factors and are not expected to result in an economic
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gain or loss. Additionally, such adjustments present all financial guaranty contracts on a more consistent basis of accounting, whether or not they are subject to derivative accounting rules.
3) Elimination of the after-tax fair value gains (losses) on the Company’s CCS. Such amounts are heavily affected by, and in part fluctuate with, changes in market interest rates, credit spreads and other market factors and are not expected to result in an economic gain or loss.
4) Elimination of the after-tax foreign exchange gains (losses) on remeasurement of net premium receivables and loss and LAE reserves. Long-dated receivables constitute a significant portion of the net premium receivable balance and represent the present value of future contractual or expected collections. Therefore, the current period’s foreign exchange remeasurement gains (losses) are not necessarily indicative of the total foreign exchange gains (losses) that the Company will ultimately recognize.
5) Elimination of the effects of consolidating FG VIEs in order to present all financial guaranty contracts on a more consistent basis of accounting, whether or not GAAP requires consolidation. GAAP requires the Company to consolidate certain VIEs that have issued debt obligations insured by the Company even though the Company does not own such VIEs.
Adjusted Book Value and Operating Shareholders’ Equity
Management also uses adjusted book value to measure the intrinsic value of the Company, excluding franchise value. Growth in adjusted book value is one of the key financial measures used in determining the amount of certain long term compensation to management and employees and used by rating agencies and investors.
Reconciliation of Shareholders’ Equity
to Adjusted Book Value
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||
Total | Per Share | Total | Per Share | ||||||||||||
(dollars in millions, except per share amounts) | |||||||||||||||
Shareholders’ equity | $ | 5,758 | $ | 36.37 | $ | 5,115 | $ | 28.07 | |||||||
Less after-tax adjustments: | |||||||||||||||
Effect of consolidating FG VIEs | (44 | ) | (0.28 | ) | (172 | ) | (0.95 | ) | |||||||
Non-credit impairment unrealized fair value gains (losses) on credit derivatives | (527 | ) | (3.33 | ) | (1,052 | ) | (5.77 | ) | |||||||
Fair value gains (losses) on CCS | 23 | 0.14 | 30 | 0.16 | |||||||||||
Unrealized gain (loss) on investment portfolio excluding foreign exchange effect | 373 | 2.36 | 145 | 0.80 | |||||||||||
Operating shareholders’ equity | 5,933 | 37.48 | 6,164 | 33.83 | |||||||||||
After-tax adjustments: | |||||||||||||||
Less: Deferred acquisition costs | 156 | 0.99 | 161 | 0.88 | |||||||||||
Plus: Net present value of estimated net future credit derivative revenue | 109 | 0.69 | 146 | 0.80 | |||||||||||
Plus: Net unearned premium reserve on financial guaranty contracts in excess of expected loss to be expensed | 2,609 | 16.48 | 2,884 | 15.83 | |||||||||||
Adjusted book value | $ | 8,495 | $ | 53.66 | $ | 9,033 | $ | 49.58 | |||||||
As of December 31, 2014, shareholders’ equity increased to $5.8 billion from $5.1 billion at December 31, 2013 due to net income and an increase in fair value of the available-for-sale portfolio in 2014, partially offset by share repurchases and dividends. Operating shareholders' equity decreased due primarily to share repurchases and dividends in 2014, which was partially offset by positive operating income. Adjusted book value decreased due mainly to share repurchases and dividends. Operating shareholders' equity per share and adjusted book value per share increased due primarily to the repurchase of 24.4 million common shares in 2014.
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Management believes that operating shareholders’ equity is a useful measure because it presents the equity of the Company with all financial guaranty contracts accounted for on a more consistent basis and excludes fair value adjustments that are not expected to result in economic gain or loss. Many investors, analysts and financial news reporters use operating shareholders’ equity as the principal financial measure for valuing AGL’s current share price or projected share price and also as the basis of their decision to recommend, buy or sell AGL’s common shares. Many of the Company’s fixed income investors also use operating shareholders’ equity to evaluate the Company’s capital adequacy. Operating shareholders’ equity is the basis of the calculation of adjusted book value (see below). Operating shareholders’ equity is defined as shareholders’ equity attributable to Assured Guaranty Ltd., as reported under GAAP, adjusted for the following:
1) Elimination of the effects of consolidating FG VIEs in order to present all financial guaranty contracts on a more consistent basis of accounting, whether or not GAAP requires consolidation. GAAP requires the Company to consolidate certain VIEs that have issued debt obligations insured by the Company even though the Company does not own such VIEs.
2) Elimination of the after-tax non-credit impairment unrealized fair value gains (losses) on credit derivatives, which is the amount in excess of the present value of the expected estimated economic credit losses, and non-economic payments. Such fair value adjustments are heavily affected by, and in part fluctuate with, changes in market interest rates, credit spreads and other market factors and are not expected to result in an economic gain or loss.
3) Elimination of the after-tax fair value gains (losses) on the Company’s CCS. Such amounts are heavily affected by, and in part fluctuate with, changes in market interest rates, credit spreads and other market factors and are not expected to result in an economic gain or loss.
4) Elimination of the after-tax unrealized gains (losses) on the Company’s investments that are recorded as a component of accumulated other comprehensive income (“AOCI”) (excluding foreign exchange remeasurement). The AOCI component of the fair value adjustment on the investment portfolio is not deemed economic because the Company generally holds these investments to maturity and therefore should not recognize an economic gain or loss.
Management believes that adjusted book value is a useful measure because it enables an evaluation of the net present value of the Company’s in-force premiums and revenues in addition to operating shareholders’ equity. The premiums and revenues included in adjusted book value will be earned in future periods, but actual earnings may differ materially from the estimated amounts used in determining current adjusted book value due to changes in foreign exchange rates, prepayment speeds, terminations, credit defaults and other factors. Many investors, analysts and financial news reporters use adjusted book value to evaluate AGL’s share price and as the basis of their decision to recommend, buy or sell the AGL common shares. Adjusted book value is operating shareholders’ equity, as defined above, further adjusted for the following:
1) Elimination of after-tax deferred acquisition costs, net. These amounts represent net deferred expenses that have already been paid or accrued and will be expensed in future accounting periods.
2) Addition of the after-tax net present value of estimated net future credit derivative revenue. See below.
3) Addition of the after-tax value of the unearned premium reserve on financial guaranty contracts in excess of expected loss to be expensed, net of reinsurance. This amount represents the expected future net earned premiums, net of expected losses to be expensed, which are not reflected in GAAP equity.
Net Present Value of Estimated Net Future Credit Derivative Revenue
Management believes that this amount is a useful measure because it enables an evaluation of the value of future estimated credit derivative revenue. There is no corresponding GAAP financial measure. This amount represents the present value of estimated future revenue from the Company’s credit derivative in-force book of business, net of reinsurance, ceding commissions and premium taxes, for contracts without expected economic losses, and is discounted at 6%. Estimated net future credit derivative revenue may change from period to period due to changes in foreign exchange rates, prepayment speeds, terminations, credit defaults or other factors that affect par outstanding or the ultimate maturity of an obligation.
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PVP or Present Value of New Business Production
Reconciliation of PVP to Gross Written Premiums
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Total PVP | $ | 168 | $ | 141 | $ | 210 | |||||
Less: Financial guaranty installment premium PVP | 42 | 26 | 45 | ||||||||
Total: Financial guaranty upfront gross written premiums | 126 | 115 | 165 | ||||||||
Plus: Financial guaranty installment gross written premiums and other GAAP adjustments | (22 | ) | 8 | 88 | |||||||
Total gross written premiums | $ | 104 | $ | 123 | $ | 253 | |||||
Management believes that PVP is a useful measure because it enables the evaluation of the value of new business production for the Company by taking into account the value of estimated future installment premiums on all new contracts underwritten in a reporting period as well as premium supplements and additional installment premium on existing contracts as to which the issuer has the right to call the insured obligation but has not exercised such right, whether in insurance or credit derivative contract form, which GAAP gross premiums written and the net credit derivative premiums received and receivable portion of net realized gains and other settlements on credit derivatives (“Credit Derivative Revenues”) do not adequately measure. PVP in respect of financial guaranty contracts written in a specified period is defined as gross upfront and installment premiums received and the present value of gross estimated future installment premiums, in each case, discounted at 6%. For purposes of the PVP calculation, management discounts estimated future installment premiums on insurance contracts at 6%, while under GAAP, these amounts are discounted at a risk free rate. Additionally, under GAAP, management records future installment premiums on financial guaranty insurance contracts covering non-homogeneous pools of assets based on the contractual term of the transaction, whereas for PVP purposes, management records an estimate of the future installment premiums the Company expects to receive, which may be based upon a shorter period of time than the contractual term of the transaction. Actual future net earned or written premiums and Credit Derivative Revenues may differ from PVP due to factors including, but not limited to, changes in foreign exchange rates, prepayment speeds, terminations, credit defaults, or other factors that affect par outstanding or the ultimate maturity of an obligation.
Insured Portfolio
The following tables present the insured portfolio by asset class net of cessions to reinsurers. It includes all financial guaranty contracts outstanding as of the dates presented, regardless of the form written (i.e., credit derivative form or traditional financial guaranty insurance form) or the applicable accounting model (i.e., insurance, derivative or VIE consolidation).
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Net Par Outstanding and Average Internal Rating by Sector
As of December 31, 2014 | As of December 31, 2013 | |||||||||||
Sector | Net Par Outstanding | Avg. Rating | Net Par Outstanding | Avg. Rating | ||||||||
(dollars in millions) | ||||||||||||
Public finance: | ||||||||||||
U.S.: | ||||||||||||
General obligation | $ | 140,276 | A | $ | 155,277 | A+ | ||||||
Tax backed | 62,525 | A | 66,824 | A+ | ||||||||
Municipal utilities | 52,090 | A | 56,324 | A | ||||||||
Transportation | 27,823 | A | 30,830 | A | ||||||||
Healthcare | 14,848 | A | 16,132 | A | ||||||||
Higher education | 13,099 | A | 14,071 | A | ||||||||
Infrastructure finance | 4,181 | BBB | 4,114 | BBB | ||||||||
Housing | 2,779 | A+ | 3,386 | A+ | ||||||||
Investor-owned utilities | 944 | A- | 991 | A- | ||||||||
Other public finance—U.S. | 3,558 | A | 4,232 | A | ||||||||
Total public finance—U.S. | 322,123 | A | 352,181 | A | ||||||||
Non-U.S.: | ||||||||||||
Infrastructure finance | 12,808 | BBB | 14,703 | BBB | ||||||||
Regulated utilities | 10,914 | BBB+ | 11,205 | BBB+ | ||||||||
Pooled infrastructure | 2,420 | AA | 2,520 | A | ||||||||
Other public finance—non-U.S. | 5,217 | A | 5,570 | A | ||||||||
Total public finance—non-U.S. | 31,359 | BBB+ | 33,998 | BBB+ | ||||||||
Total public finance | 353,482 | A | 386,179 | A | ||||||||
Structured finance: | ||||||||||||
U.S.: | ||||||||||||
Pooled corporate obligations | 20,646 | AAA | 31,325 | AAA | ||||||||
RMBS | 9,417 | BBB- | 13,721 | BBB- | ||||||||
Insurance securitizations | 3,433 | A- | 3,035 | A- | ||||||||
Financial products | 2,276 | AA- | 2,709 | AA- | ||||||||
Consumer receivables | 2,099 | BBB+ | 2,198 | BBB+ | ||||||||
CMBS and other commercial real estate related exposures | 1,957 | AAA | 3,952 | AAA | ||||||||
Commercial receivables | 560 | BBB+ | 911 | A- | ||||||||
Structured credit | 69 | BB | 69 | BB | ||||||||
Other structured finance—U.S. | 714 | AA | 987 | A- | ||||||||
Total structured finance—U.S. | 41,171 | AA- | 58,907 | AA- | ||||||||
Non-U.S.: | ||||||||||||
Pooled corporate obligations | 6,604 | AA+ | 11,058 | AAA | ||||||||
Commercial receivables | 944 | BBB | 1,263 | BBB+ | ||||||||
RMBS | 794 | A | 1,146 | AA- | ||||||||
Structured credit | 9 | BBB+ | 176 | BBB | ||||||||
Other structured finance—non-U.S. | 725 | AA | 378 | AAA | ||||||||
Total structured finance—non-U.S. | 9,076 | AA | 14,021 | AA+ | ||||||||
Total structured finance | 50,247 | AA- | 72,928 | AA | ||||||||
Total net par outstanding | $ | 403,729 | A | $ | 459,107 | A | ||||||
The December 31, 2014 and 2013 amounts above include $26.3 billion and $38.1 billion, respectively, of AGM structured finance net par outstanding. AGM has not insured a mortgage-backed transaction since January 2008 and announced
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in August 2008 that it would no longer issue new policies on structured finance obligations. The structured finance transactions that remain in AGM’s insured portfolio have an average internal rating by the Company of double-A. Management expects AGM’s structured finance portfolio to run-off rapidly: 30% by year-end 2015, 73% by year end 2017, and 81% by year-end 2019.
The following tables set forth the Company’s net financial guaranty portfolio by internal rating.
Financial Guaranty Portfolio by Internal Rating
As of December 31, 2014
Public Finance U.S. | Public Finance Non-U.S. | Structured Finance U.S | Structured Finance Non-U.S | Total | |||||||||||||||||||||||||||||||
Rating Category | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | |||||||||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||||||||||||
AAA | $ | 4,082 | 1.3 | % | $ | 615 | 2.0 | % | $ | 20,037 | 48.7 | % | $ | 5,409 | 59.6 | % | $ | 30,143 | 7.5 | % | |||||||||||||||
AA | 90,464 | 28.1 | 2,785 | 8.9 | 8,213 | 19.9 | 503 | 5.5 | 101,965 | 25.3 | |||||||||||||||||||||||||
A | 176,298 | 54.7 | 7,192 | 22.9 | 2,940 | 7.1 | 445 | 4.9 | 186,875 | 46.3 | |||||||||||||||||||||||||
BBB | 43,429 | 13.5 | 19,363 | 61.7 | 1,795 | 4.4 | 1,912 | 21.1 | 66,499 | 16.4 | |||||||||||||||||||||||||
BIG | 7,850 | 2.4 | 1,404 | 4.5 | 8,186 | 19.9 | 807 | 8.9 | 18,247 | 4.5 | |||||||||||||||||||||||||
Net par outstanding (1) | $ | 322,123 | 100.0 | % | $ | 31,359 | 100.0 | % | $ | 41,171 | 100.0 | % | $ | 9,076 | 100.0 | % | $ | 403,729 | 100.0 | % | |||||||||||||||
_____________________
(1) | Excludes $1.3 billion in loss mitigation securities insured and held by the Company as of December 31, 2014, which are primarily in the BIG category. |
Financial Guaranty Portfolio by Internal Rating
As of December 31, 2013
Public Finance U.S. | Public Finance Non-U.S. | Structured Finance U.S | Structured Finance Non-U.S | Total | |||||||||||||||||||||||||||||||
Rating Category | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | |||||||||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||||||||||||
AAA | $ | 4,998 | 1.4 | % | $ | 1,016 | 3.0 | % | $ | 32,317 | 54.9 | % | $ | 9,684 | 69.1 | % | $ | 48,015 | 10.5 | % | |||||||||||||||
AA | 107,503 | 30.5 | 422 | 1.2 | 9,431 | 16.0 | 577 | 4.1 | 117,933 | 25.7 | |||||||||||||||||||||||||
A | 192,841 | 54.8 | 9,453 | 27.9 | 2,580 | 4.4 | 742 | 5.3 | 205,616 | 44.8 | |||||||||||||||||||||||||
BBB | 37,745 | 10.7 | 21,499 | 63.2 | 3,815 | 6.4 | 1,946 | 13.9 | 65,005 | 14.1 | |||||||||||||||||||||||||
BIG | 9,094 | 2.6 | 1,608 | 4.7 | 10,764 | 18.3 | 1,072 | 7.6 | 22,538 | 4.9 | |||||||||||||||||||||||||
Net par outstanding (1) | $ | 352,181 | 100.0 | % | $ | 33,998 | 100.0 | % | $ | 58,907 | 100.0 | % | $ | 14,021 | 100.0 | % | $ | 459,107 | 100.0 | % | |||||||||||||||
_____________________
(1) | Excludes $1.2 billion in loss mitigation securities insured and held by the Company as of December 31, 2013, which are primarily in the BIG category. |
The tables below show the Company's ten largest U.S. public finance, U.S. structured finance and non-U.S. exposures by revenue source, excluding related authorities and public corporations, as of December 31, 2014:
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Ten Largest U.S. Public Finance Exposures
by Revenue Source
As of December 31, 2014
Net Par Outstanding | Percent of Total U.S. Public Finance Net Par Outstanding | Rating | ||||||
(dollars in millions) | ||||||||
New Jersey (State of) | $ | 3,947 | 1.2 | % | A- | |||
California (State of) | 3,222 | 1.0 | % | A- | ||||
New York (City of) New York | 2,530 | 0.8 | % | AA- | ||||
Massachusetts (Commonwealth of) | 2,230 | 0.7 | % | AA | ||||
Illinois (State of) | 2,193 | 0.7 | % | A- | ||||
New York (State of) | 2,146 | 0.7 | % | A+ | ||||
Miami-Dade County Florida Aviation Authority - Miami International Airport | 2,144 | 0.7 | % | A | ||||
Chicago (City of) Illinois | 2,108 | 0.7 | % | BBB+ | ||||
Puerto Rico General Obligation, Appropriations and Guarantees of the Commonwealth | 1,823 | 0.6 | % | BB | ||||
Los Angeles, California Unified School District | 1,777 | 0.6 | % | AA- | ||||
Total of top ten U.S. public finance exposures | $ | 24,120 | 7.7 | % | ||||
Ten Largest U.S. Structured Finance Exposures
As of December 31, 2014
Net Par Outstanding | Percent of Total U.S. Structured Finance Net Par Outstanding | Rating | ||||||
(dollars in millions) | ||||||||
Fortress Credit Opportunities I, LP. | $ | 1,217 | 3.0 | % | AA | |||
Private Other Structured Finance Transaction | 800 | 1.9 | % | AA | ||||
Stone Tower Credit Funding | 790 | 1.9 | % | AAA | ||||
Synthetic Investment Grade Pooled Corporate CDO | 767 | 1.9 | % | AAA | ||||
Synthetic Investment Grade Pooled Corporate CDO | 763 | 1.9 | % | AAA | ||||
Synthetic Investment Grade Pooled Corporate CDO | 745 | 1.8 | % | AAA | ||||
Synthetic Investment Grade Pooled Corporate CDO | 666 | 1.6 | % | AAA | ||||
Synthetic Investment Grade Pooled Corporate CDO | 655 | 1.6 | % | AAA | ||||
Synthetic Investment Grade Pooled Corporate CDO | 516 | 1.3 | % | AAA | ||||
Private US Insurance Securitization | 500 | 1.2 | % | AA | ||||
Total of top ten U.S. structured finance exposures | $ | 7,419 | 18.1 | % | ||||
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Ten Largest Non-U.S. Exposures
As of December 31, 2014
Country | Net Par Outstanding | Percent of Total Non-U.S. Net Par Outstanding | Rating | |||||||
(dollars in millions) | ||||||||||
Quebec Province | Canada | $ | 2,366 | 5.9 | % | A+ | ||||
Thames Water Utility Finance PLC | United Kingdom | 1,438 | 3.6 | % | A- | |||||
Channel Link Enterprises Finance PLC | France, United Kingdom | 908 | 2.2 | % | BBB | |||||
Southern Gas Networks PLC | United Kingdom | 902 | 2.2 | % | BBB | |||||
Societe des Autoroutes du Nord et de l'Est de France S.A. | France | 811 | 2.0 | % | BBB+ | |||||
Capital Hospitals (Issuer) PLC | United Kingdom | 786 | 1.9 | % | BBB- | |||||
Sydney Airport Finance Company | Australia | 748 | 1.9 | % | BBB | |||||
International Infrastructure Pool | United Kingdom | 728 | 1.8 | % | AA | |||||
Southern Water Services Limited | United Kingdom | 691 | 1.7 | % | A- | |||||
International Infrastructure Pool | United Kingdom | 656 | 1.6 | % | AA | |||||
Total of top ten non-U.S. exposures | $ | 10,034 | 24.8 | % | ||||||
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Financial Guaranty Portfolio by Geographic Area
The following table sets forth the geographic distribution of the Company's financial guaranty portfolio.
Geographic Distribution
of Financial Guaranty Portfolio
As of December 31, 2014
Number of Risks | Net Par Outstanding | Percent of Total Net Par Outstanding | |||||||
(dollars in millions) | |||||||||
U.S.: | |||||||||
U.S. Public Finance: | |||||||||
California | 1,465 | $ | 50,668 | 12.6 | % | ||||
Pennsylvania | 1,009 | 26,173 | 6.5 | ||||||
New York | 995 | 26,044 | 6.5 | ||||||
Texas | 1,239 | 25,449 | 6.3 | ||||||
Illinois | 830 | 22,825 | 5.7 | ||||||
Florida | 384 | 19,470 | 4.8 | ||||||
New Jersey | 602 | 13,558 | 3.4 | ||||||
Michigan | 668 | 12,739 | 3.2 | ||||||
Georgia | 192 | 8,217 | 2.0 | ||||||
Ohio | 507 | 7,818 | 1.9 | ||||||
Other states and U.S. territories | 4,174 | 109,162 | 27.0 | ||||||
Total U.S. public finance | 12,065 | 322,123 | 79.9 | ||||||
U.S. Structured finance (multiple states) | 839 | 41,171 | 10.2 | ||||||
Total U.S. | 12,904 | 363,294 | 90.1 | ||||||
Non-U.S.: | |||||||||
United Kingdom | 114 | 19,856 | 4.9 | ||||||
Australia | 26 | 4,121 | 1.0 | ||||||
Canada | 10 | 3,526 | 0.9 | ||||||
France | 20 | 2,820 | 0.7 | ||||||
Italy | 9 | 1,501 | 0.4 | ||||||
Other | 78 | 8,611 | 2.0 | ||||||
Total non-U.S. | 257 | 40,435 | 9.9 | ||||||
Total | 13,161 | $ | 403,729 | 100.0 | % | ||||
Selected European Exposure
Several European countries have experienced significant economic, fiscal and / or political strains such that the likelihood of default on obligations with a nexus to those countries may be higher than the Company anticipated when such factors did not exist. The Company has identified those European countries where it has exposure and where it believes heightened uncertainties exist to be: Hungary, Italy, Portugal and Spain (the “Selected European Countries”). The Company selected these European countries based on its view that their credit fundamentals have weakened as a result of the global financial crisis, as well as on published reports identifying countries that may be experiencing reduced demand for their sovereign debt in the current environment. Previously the Company had included Ireland on this list, but the Company removed it during third quarter 2014 because of Ireland's strengthening economic performance and improving prospects; in 2014, Ireland's long-term foreign currency rating was upgraded one notch by S&P (to ‘A-’) and three notches by Moody’s (to ‘Baa1’). The Company has in the past also included Greece on the list, but the Company no longer has any meaningful exposure to Greece. See “—Selected European Countries” below for an explanation of the circumstances in each country leading the Company to select that country for further discussion.
104
Direct Economic Exposure to the Selected European Countries
The Company’s direct economic exposure to the Selected European Countries (based on par for financial guaranty contracts and notional amount for financial guaranty contracts accounted for as derivatives) is shown in the following tables, both gross and net of ceded reinsurance:
Gross Direct Economic Exposure
to Selected European Countries(1)
As of December 31, 2014
Hungary | Italy | Portugal | Spain | Total | |||||||||||||||
(in millions) | |||||||||||||||||||
Sovereign and sub-sovereign exposure: | |||||||||||||||||||
Non-infrastructure public finance (2) | $ | — | $ | 1,174 | $ | 103 | $ | 384 | $ | 1,661 | |||||||||
Infrastructure finance | 334 | 14 | 11 | 137 | 496 | ||||||||||||||
Total sovereign and sub-sovereign exposure | 334 | 1,188 | 114 | 521 | 2,157 | ||||||||||||||
Non-sovereign exposure: | |||||||||||||||||||
Regulated utilities | — | 239 | — | — | 239 | ||||||||||||||
RMBS | 195 | 323 | — | — | 518 | ||||||||||||||
Total non-sovereign exposure | 195 | 562 | — | — | 757 | ||||||||||||||
Total | $ | 529 | $ | 1,750 | $ | 114 | $ | 521 | $ | 2,914 | |||||||||
Total BIG | $ | 451 | $ | — | $ | 114 | $ | 521 | $ | 1,086 | |||||||||
Net Direct Economic Exposure
to Selected European Countries(1)
As of December 31, 2014
Hungary | Italy | Portugal | Spain | Total | |||||||||||||||
(in millions) | |||||||||||||||||||
Sovereign and sub-sovereign exposure: | |||||||||||||||||||
Non-infrastructure public finance(2) | $ | — | $ | 878 | $ | 91 | $ | 239 | $ | 1,208 | |||||||||
Infrastructure finance | 313 | 13 | 11 | 135 | 472 | ||||||||||||||
Total sovereign and sub-sovereign exposure | 313 | 891 | 102 | 374 | 1,680 | ||||||||||||||
Non-sovereign exposure: | |||||||||||||||||||
Regulated utilities | — | 220 | — | — | 220 | ||||||||||||||
RMBS | 186 | 267 | — | — | 453 | ||||||||||||||
Total non-sovereign exposure | 186 | 487 | — | — | 673 | ||||||||||||||
Total | $ | 499 | $ | 1,378 | $ | 102 | $ | 374 | $ | 2,353 | |||||||||
Total BIG | $ | 424 | $ | — | $ | 102 | $ | 374 | $ | 900 | |||||||||
(1) While the Company’s exposures are shown in U.S. dollars, the obligations the Company insures are in various currencies, primarily Euros. One of the residential mortgage-backed securities included in the table above includes residential mortgages in both Italy and Germany, and only the portion of the transaction equal to the portion of the original mortgage pool in Italian mortgages is shown in the tables.
(2) | The exposure shown in the "Non-infrastructure public finance" category is from transactions backed by receivable payments from sub-sovereigns in Italy, Spain and Portugal. |
The tables above include the par amount of financial guaranty contracts accounted for as derivatives of $120 million with a fair value of $4 million, net of reinsurance. The Company’s credit derivative transactions are governed by ISDA documentation, and the Company is required to make a loss payment on them only upon the occurrence of one or more defined credit events with respect to the referenced securities or loans.
105
The Company purchases reinsurance in the ordinary course to cover both its financial guaranty insurance and credit derivative exposures. Aside from this type of coverage the Company does not purchase credit default protection to manage the risk in its financial guaranty business. Rather, the Company has reduced its risks by ceding a portion of its business (including its financial guaranty contracts accounted for as derivatives) to third-party reinsurers that are generally required to pay their proportionate share of claims paid by the Company, and the net amounts shown above are net of such third-party reinsurance (reinsurance of financial guaranty contracts accounted for as derivatives is accounted for as a purchased derivative). See Note 14, Reinsurance and Other Monoline Exposures, of the Financial Statements and Supplementary Data.
Indirect Exposure to Selected European Countries
The Company has excluded from the exposure tables above its indirect economic exposure to the Selected European Countries through insurance it provides on pooled corporate and commercial receivables transactions. The Company considers economic exposure to a Selected European Country to be indirect when that exposure relates to only a small portion of an insured transaction that otherwise is not related to that Selected European Country.
The Company’s pooled corporate obligations with indirect exposure to Selected European Countries are highly diversified in terms of obligors and, except in the case of TruPS CDOs or transactions backed by perpetual preferred securities, highly diversified in terms of industry. Most pooled corporate obligations are structured to limit exposure to any given obligor and any given non-U.S. country or region and generally benefit from embedded credit enhancement which allows a transaction a certain level of losses in the underlying collateral without causing the Company to pay a claim. The Company’s commercial receivable transactions with indirect exposure to Selected European Countries are rail car lease transactions and aircraft lease transactions where some of the lessees have a nexus with the Selected European Countries. Like the pooled corporate transactions, the commercial receivable transactions generally benefit from embedded credit enhancement which allows a transaction a certain level of losses in the underlying collateral without causing the Company to pay a claim.
The Company calculates indirect exposure to a country by multiplying the par amount of a transaction insured by the Company times the percent of the relevant collateral pool reported as having a nexus to the country. On that basis, the Company has calculated exposure of $418 million to Selected European Countries (plus Greece) in transactions with $11.6 billion of net par outstanding. The indirect exposure to credits with a nexus to Greece is $12 million across several highly rated pooled corporate obligations with net par outstanding of $864 million.
Selected European Countries
The Company follows and analyzes public information regarding developments in countries to which the Company has exposure, including the Selected European Countries, and utilizes this information to evaluate risks in its financial guaranty portfolio. Because the Company guarantees payments under its financial guaranty contracts, its analysis is focused primarily on the risk of payment defaults by these countries or obligors in these countries. However, material developments having an economic impact with respect to the Selected European Countries would also impact the fair value of financial guaranty contracts accounted for as derivatives and with a nexus to those countries.
The Republic of Hungary is rated “BB” and “Ba1” by S&P and Moody’s, respectively. The country continues to face significant economic and political challenges. The Company’s sovereign and sub-sovereign exposure to Hungarian credits includes an infrastructure financing dependent on payments by government agencies. The Company rates this exposure ($313 million net par) BIG. The Company is closely monitoring developments with respect to the ability and willingness of these entities to meet their payment obligations. The Company’s non-sovereign exposure to Hungary comprises covered mortgage bonds issued by Hungarian banks. The Company rates $111 million net par of the covered bonds BIG.
The Kingdom of Spain is rated “BBB” by S&P and “Baa2” by Moody’s. The country’s economy has improved during 2014, however, the strength of the recovery is uncertain given both domestic and external challenges. The Company’s sovereign and sub-sovereign exposure to Spanish credits includes infrastructure financings dependent on payments by sub-sovereigns and government agencies, financings dependent on lease and other payments by sub-sovereigns and government agencies, and an issuance by a regulated utility. The Company rates all ($374 million aggregate net par) of its exposure to sovereign and sub-sovereign credits in Spain BIG. The Company is closely monitoring developments with respect to the ability and willingness of these entities to meet their payment obligations.
The Republic of Portugal is rated “BB” and “Ba1” by S&P and Moody's, respectively. Portugal’s economy has exhibited some improvement but continues to face significant challenges ahead, including meeting budget deficit targets while achieving sustainable growth. The Company’s exposure to sovereign and sub-sovereign Portuguese credits includes financings dependent on lease payments by sub-sovereigns and government agencies and infrastructure financings dependent on payments
106
by sub-sovereigns and government agencies. The Company rates four of these transactions ($102 million aggregate net par) BIG. The Company is closely monitoring developments with respect to the ability and willingness of these entities to meet their payment obligations.
The Republic of Italy is rated “BBB-” and “Baa2” by S&P and Moody’s, respectively. S&P downgraded Italy from “BBB” on December 5, 2014 due to the country’s weak economic prospects, which continue to undermine public debt dynamics. The Company’s sovereign and sub-sovereign exposure to Italy depends on payments by Italian governmental entities in connection with infrastructure financings or for services already rendered. The Company’s non-sovereign Italian exposure is comprised primarily of securities backed by Italian residential mortgages or in one case a government-sponsored water utility. The Company is closely monitoring the ability and willingness of these obligors to make timely payments on their obligations.
Identifying Exposure to Selected European Countries
When the Company directly insures an obligation, it assigns the obligation to a geographic location or locations based on its view of the geographic location of the risk. For most exposures this can be a relatively straight-forward determination as, for example, a debt issue supported by availability payments for a toll road in a particular country. The Company may also assign portions of a risk to more than one geographic location as it has, for example, in a residential mortgage backed security backed by residential mortgage loans in both Germany and Italy. The Company may also have exposures to the Selected European Countries in business assumed from other monoline insurance companies. In the case of assumed business, the Company depends upon geographic information provided by the primary insurer.
Exposure to Puerto Rico
The Company insures general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $4.9 billion net par as of December 31, 2014. The Company rates $4.7 billion net par of that amount BIG; included in that amount are the obligations of Puerto Rico Highway and Transportation Authority (“PRHTA”) (transportation), Puerto Rico Electric Power Authority (“PREPA”), and PRHTA (highway).
Puerto Rico has experienced significant general fund budget deficits in recent years. These deficits have been covered primarily with the net proceeds of bond issuances, interim financings provided by GDB and, in some cases, one-time revenue measures or expense adjustment measures. In addition to high debt levels, Puerto Rico faces a challenging economic environment.
In June 2014, the Puerto Rico legislature passed the Recovery Act in order to provide a legislative framework for certain public corporations experiencing severe financial stress to restructure their debt, including PRHTA and PREPA. Subsequently, the Commonwealth stated PREPA might need to seek relief under the Recovery Act due to liquidity constraints, and disclosed PREPA had utilized approximately $42 million on deposit in its reserve account in order to pay debt service due on its bonds on July 1, 2014.
In August 2014, PREPA entered into forbearance agreements with the GDB, its bank lenders, and bondholders and financial guaranty insurers (including AGM and AGC) that hold or guarantee more than 60% of PREPA's outstanding bonds, in order to address its near-term liquidity issues. Creditors, including AGM and AGC, agreed not to exercise available rights and remedies until March 31, 2015, and the bank lenders agreed to extend the maturity of two revolving lines of credit to the same date. PREPA agreed it would continue to make principal and interest payments on its outstanding bonds, and interest payments on its lines of credit. It also agreed it would develop a five year business plan and a recovery program in respect of its operations; a preliminary business plan was released in December 2014. Creditors, including AGM and AGC, have begun discussions among themselves and with PREPA regarding potentially extending the forbearance agreements beyond March 31, 2015, but there can be no assurance that such discussions will result in such an extension.
Investors in bonds issued by PREPA had filed suit in the United States District Court for the District of Puerto Rico asserting the Recovery Act violates the U.S. Constitution. On February 6, 2015, the U.S. District Court for the District of Puerto Rico ruled the Recovery Act is preempted by the U.S. Bankruptcy Code and is therefore void; on February 19, 2015, the Commonwealth appealed the ruling to the U.S. Court of Appeals for the First Circuit. In addition, the Commonwealth's Resident Commissioner has introduced a bill to the U.S. Congress that, if passed, would enable the Commonwealth to authorize one or more of its public corporations to restructure their debts under chapter 9 of the U.S Bankruptcy Code if they were to become insolvent. The passage of the Recovery Act, its subsequent invalidation, and the introduction of legislation that would enable the Commonwealth to authorize chapter 9 protection for its public corporations have resulted in uncertainty among investors about the rights of creditors of the Commonwealth and its related authorities and public corporations.
107
Following the enactment of the Recovery Act, S&P, Moody’s and Fitch Ratings lowered the credit rating of the Commonwealth’s bonds and the ratings on certain of its public corporations. In February 2015, S&P and Moody’s each again lowered the credit rating of the Commonwealth's bonds and the ratings on certain of its public corporations. The Commonwealth has disclosed its liquidity has been adversely affected by rating agency downgrades and by the limited market access for its debt, and also noted it has relied on short-term financings and interim loans from the GDB and other private lenders, which reliance has constrained its liquidity and increased its near-term refinancing risk.
In December 2014, Puerto Rico's legislature approved a bill designed to stabilize PRHTA and improve the liquidity of the GDB. Signed by the governor on January 15, 2015, the legislation provides for certain tax revenues that would support PRHTA and require the transfer of certain liabilities and revenues from PHRTA to another authority, as well as requiring the transfer of the operations of poorly performing transit facilities to a new authority.
108
Net Exposure to Puerto Rico
As of December 31, 2014
Net Par Outstanding | ||||||||||||||||||||||||||
AGM Consolidated | AGC Consolidated | AG Re (1) Consolidated | Eliminations (2) | Total Net Par Outstanding | Gross Par Outstanding | Internal Rating | ||||||||||||||||||||
(in millions) | ||||||||||||||||||||||||||
Exposures subject to the Now Voided Recovery Act (3): | ||||||||||||||||||||||||||
PRHTA (Transportation revenue) | $ | 303 | $ | 392 | $ | 229 | $ | (80 | ) | $ | 844 | $ | 912 | BB- | ||||||||||||
PREPA | 464 | 53 | 255 | — | 772 | 1,006 | B- | |||||||||||||||||||
Puerto Rico Aqueduct and Sewer Authority | — | 288 | 96 | — | 384 | 384 | BB- | |||||||||||||||||||
PRHTA (Highway revenue) | 197 | 24 | 52 | — | 273 | 582 | BB | |||||||||||||||||||
Puerto Rico Convention Center District Authority | — | 87 | 87 | — | 174 | 174 | BB- | |||||||||||||||||||
Total | 964 | 844 | 719 | (80 | ) | 2,447 | 3,058 | |||||||||||||||||||
Exposures not subject to the Now Voided Recovery Act: | ||||||||||||||||||||||||||
Commonwealth of Puerto Rico - General Obligation Bonds | 749 | 417 | 506 | — | 1,672 | 1,844 | BB | |||||||||||||||||||
Puerto Rico Municipal Finance Agency | 223 | 44 | 132 | — | 399 | 656 | BB- | |||||||||||||||||||
Puerto Rico Sales Tax Financing Corporation | 261 | — | 8 | — | 269 | 269 | BBB | |||||||||||||||||||
Puerto Rico Public Buildings Authority | 18 | 41 | 41 | — | 100 | 156 | BB | |||||||||||||||||||
GDB | — | 33 | — | — | 33 | 33 | BB | |||||||||||||||||||
Puerto Rico Infrastructure Finance Authority (“PRIFA”) | — | 10 | 8 | — | 18 | 18 | BB- | |||||||||||||||||||
University of Puerto Rico | — | 1 | — | — | 1 | 1 | BB- | |||||||||||||||||||
Total | 1,251 | 546 | 695 | — | 2,492 | 2,977 | ||||||||||||||||||||
Total net exposure to Puerto Rico | $ | 2,215 | $ | 1,390 | $ | 1,414 | $ | (80 | ) | $ | 4,939 | $ | 6,035 | |||||||||||||
___________________
(1) | Assured Guaranty Re Ltd. |
(2) | Net par outstanding eliminations relate to second-to-pay policies under which an Assured Guaranty insurance subsidiary guarantees an obligation already insured by another Assured Guaranty insurance subsidiary. |
(3) | On February 6, 2015, the U.S. District Court for the District of Puerto Rico ruled that the Recovery Act is preempted by the Federal Bankruptcy Code and is therefore void. On February 19, 2015, the Commonwealth appealed the ruling to the U.S. Court of Appeals for the First Circuit. |
The following table shows the scheduled amortization of the general obligation bonds of Puerto Rico and various obligations of its related authorities and public corporations insured by the Company. The Company guarantees payments of interest and principal when those amounts are scheduled to be paid and cannot be required to pay on an accelerated basis. In the event that obligors default on their obligations, the Company would only pay the shortfall between the principal and interest due in any given period and the amount paid by the obligors.
109
Amortization Schedule
of Net Par Outstanding of Puerto Rico
As of December 31, 2014
Scheduled Net Par Amortization | ||||||||||||||||||||||||||||||||||||||||||||||||
2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 -2029 | 2030 -2034 | 2035 -2039 | 2040 -2044 | 2045 -2047 | Total | |||||||||||||||||||||||||||||||||
(in millions) | ||||||||||||||||||||||||||||||||||||||||||||||||
Exposures subject to the Now Voided Recovery Act: | ||||||||||||||||||||||||||||||||||||||||||||||||
PRHTA (Transportation revenue) | $ | 22 | $ | 29 | $ | 32 | $ | 39 | $ | 26 | $ | 21 | $ | 16 | $ | 17 | $ | 17 | $ | 1 | $ | 128 | $ | 137 | $ | 281 | $ | 78 | $ | — | $ | 844 | ||||||||||||||||
PREPA | 73 | 19 | 4 | 4 | 24 | 40 | 20 | 19 | 78 | 74 | 300 | 113 | 4 | — | — | 772 | ||||||||||||||||||||||||||||||||
Puerto Rico Aqueduct and Sewer Authority | 14 | 15 | — | — | — | — | — | — | — | — | 109 | — | — | — | 246 | 384 | ||||||||||||||||||||||||||||||||
PRHTA (Highway revenue) | 6 | 10 | 5 | 5 | 11 | 12 | 15 | 6 | 7 | 7 | 20 | 114 | 55 | — | — | 273 | ||||||||||||||||||||||||||||||||
Puerto Rico Convention Center District Authority | 11 | 11 | — | — | — | — | — | — | — | — | 19 | 76 | 57 | — | — | 174 | ||||||||||||||||||||||||||||||||
Total | 126 | 84 | 41 | 48 | 61 | 73 | 51 | 42 | 102 | 82 | 576 | 440 | 397 | 78 | 246 | 2,447 | ||||||||||||||||||||||||||||||||
Exposures not subject to the Now Voided Recovery Act: | ||||||||||||||||||||||||||||||||||||||||||||||||
Commonwealth of Puerto Rico - General Obligation Bonds | 109 | 127 | 95 | 64 | 82 | 137 | 16 | 37 | 14 | 66 | 278 | 381 | 266 | — | — | 1,672 | ||||||||||||||||||||||||||||||||
Puerto Rico Municipal Finance Authority | 51 | 48 | 41 | 43 | 39 | 35 | 30 | 30 | 16 | 12 | 52 | 2 | — | — | — | 399 | ||||||||||||||||||||||||||||||||
Puerto Rico Sales Tax Financing Corporation | (1 | ) | (1 | ) | (1 | ) | (1 | ) | (1 | ) | (1 | ) | (2 | ) | (2 | ) | 1 | 0 | (10 | ) | 34 | (1 | ) | 255 | — | 269 | ||||||||||||||||||||||
Puerto Rico Public Buildings Authority | 12 | 8 | 30 | — | 5 | 10 | 12 | 0 | 8 | 0 | 10 | 3 | 2 | — | — | 100 | ||||||||||||||||||||||||||||||||
GDB | 33 | — | — | — | — | — | — | — | — | — | — | — | — | — | — | 33 | ||||||||||||||||||||||||||||||||
PRIFA | — | — | — | 2 | — | — | — | — | 2 | — | — | — | 2 | 12 | — | 18 | ||||||||||||||||||||||||||||||||
University of Puerto Rico | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 1 | — | — | — | 1 | ||||||||||||||||||||||||||||||||
Total | 204 | 182 | 165 | 108 | 125 | 181 | 56 | 65 | 41 | 78 | 330 | 421 | 269 | 267 | — | 2,492 | ||||||||||||||||||||||||||||||||
Total net par for Puerto Rico | $ | 330 | $ | 266 | $ | 206 | $ | 156 | $ | 186 | $ | 254 | $ | 107 | $ | 107 | $ | 143 | $ | 160 | $ | 906 | $ | 861 | $ | 666 | $ | 345 | $ | 246 | $ | 4,939 | ||||||||||||||||
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Amortization Schedule
of Net Debt Service Outstanding of Puerto Rico
As of December 31, 2014
Scheduled Net Debt Service Amortization | ||||||||||||||||||||||||||||||||||||||||||||||||
2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | 2025 -2029 | 2030 -2034 | 2035 -2039 | 2040 -2044 | 2045 -2047 | Total | |||||||||||||||||||||||||||||||||
(in millions) | ||||||||||||||||||||||||||||||||||||||||||||||||
Exposures subject to the Now Voided Recovery Act: | ||||||||||||||||||||||||||||||||||||||||||||||||
PRHTA (Transportation revenue) | $ | 66 | $ | 72 | $ | 73 | $ | 79 | $ | 64 | $ | 57 | $ | 51 | $ | 51 | $ | 51 | $ | 34 | $ | 280 | $ | 257 | $ | 338 | $ | 84 | $ | — | $ | 1,557 | ||||||||||||||||
PREPA | 109 | 51 | 36 | 35 | 55 | 70 | 48 | 47 | 104 | 97 | 365 | 125 | 5 | — | — | 1,147 | ||||||||||||||||||||||||||||||||
Puerto Rico Aqueduct and Sewer Authority | 34 | 34 | 18 | 18 | 18 | 18 | 18 | 18 | 18 | 18 | 186 | 63 | 63 | 63 | 271 | 858 | ||||||||||||||||||||||||||||||||
PRHTA (Highway revenue) | 21 | 24 | 19 | 19 | 24 | 24 | 27 | 17 | 18 | 18 | 68 | 148 | 59 | — | — | 486 | ||||||||||||||||||||||||||||||||
Puerto Rico Convention Center District Authority | 19 | 18 | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 7 | 52 | 103 | 61 | — | — | 309 | ||||||||||||||||||||||||||||||||
Total | 249 | 199 | 153 | 158 | 168 | 176 | 151 | 140 | 198 | 174 | 951 | 696 | 526 | 147 | 271 | 4,357 | ||||||||||||||||||||||||||||||||
Exposures not subject to the Now Voided Recovery Act: | ||||||||||||||||||||||||||||||||||||||||||||||||
Commonwealth of Puerto Rico - General Obligation Bonds | 195 | 208 | 170 | 133 | 149 | 200 | 71 | 91 | 67 | 119 | 492 | 529 | 295 | — | — | 2,719 | ||||||||||||||||||||||||||||||||
Puerto Rico Municipal Finance Authority | 70 | 66 | 57 | 56 | 50 | 44 | 38 | 36 | 20 | 15 | 59 | 3 | — | — | — | 514 | ||||||||||||||||||||||||||||||||
Puerto Rico Sales Tax Financing Corporation | 13 | 13 | 13 | 13 | 13 | 13 | 13 | 13 | 16 | 15 | 63 | 106 | 63 | 283 | — | 650 | ||||||||||||||||||||||||||||||||
Puerto Rico Public Buildings Authority | 17 | 12 | 34 | 3 | 7 | 13 | 14 | 1 | 9 | 1 | 12 | 5 | 4 | — | — | 132 | ||||||||||||||||||||||||||||||||
GDB | 36 | — | — | — | — | — | — | — | — | — | — | — | — | — | — | 36 | ||||||||||||||||||||||||||||||||
PRIFA | 1 | 1 | 1 | 3 | 1 | 1 | 1 | 1 | 3 | 1 | 3 | 3 | 5 | 13 | — | 38 | ||||||||||||||||||||||||||||||||
University of Puerto Rico | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 1 | — | — | — | 1 | ||||||||||||||||||||||||||||||||
Total | 332 | 300 | 275 | 208 | 220 | 271 | 137 | 142 | 115 | 151 | 629 | 647 | 367 | 296 | — | 4,090 | ||||||||||||||||||||||||||||||||
Total net debt service for Puerto Rico | $ | 581 | $ | 499 | $ | 428 | $ | 366 | $ | 388 | $ | 447 | $ | 288 | $ | 282 | $ | 313 | $ | 325 | $ | 1,580 | $ | 1,343 | $ | 893 | $ | 443 | $ | 271 | $ | 8,447 | ||||||||||||||||
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Financial Guaranty Portfolio by Issue Size
The Company seeks broad coverage of the market by insuring and reinsuring small and large issues alike. The following table sets forth the distribution of the Company's portfolio by original size of the Company's exposure.
Public Finance Portfolio by Issue Size
As of December 31, 2014
Original Par Amount Per Issue | Number of Issues | Net Par Outstanding | % of Public Finance Net Par Outstanding | ||||||
(dollars in millions) | |||||||||
Less than $10 million | 16,595 | $ | 46,971 | 13.3 | % | ||||
$10 through $50 million | 6,173 | 105,720 | 29.9 | ||||||
$50 through $100 million | 1,202 | 63,564 | 18.0 | ||||||
$100 million to $200 million | 517 | 55,899 | 15.8 | ||||||
$200 million or greater | 307 | 81,328 | 23.0 | ||||||
Total | 24,794 | $ | 353,482 | 100.0 | % | ||||
Structured Finance Portfolio by Issue Size
As of December 31, 2014
Original Par Amount Per Issue | Number of Issues | Net Par Outstanding | % of Structured Finance Net Par Outstanding | ||||||
(dollars in millions) | |||||||||
Less than $10 million | 235 | $ | 121 | 0.2 | % | ||||
$10 through $50 million | 428 | 4,821 | 9.6 | ||||||
$50 through $100 million | 119 | 4,300 | 8.6 | ||||||
$100 million to $200 million | 175 | 10,531 | 21.0 | ||||||
$200 million or greater | 192 | 30,474 | 60.6 | ||||||
Total | 1,149 | $ | 50,247 | 100.0 | % | ||||
Exposure to Residential Mortgage-Backed Securities
The tables below provide information on the risk ratings and certain other risk characteristics of the Company’s financial guaranty insurance and credit derivative RMBS exposures as of December 31, 2014. U.S. RMBS exposures represent 2% of the total net par outstanding, and BIG U.S. RMBS represent 31% of total BIG net par outstanding. The tables presented provide information with respect to the underlying performance indicators of this book of business. See Note 6, Expected Loss to be Paid, of the Financial Statements and Supplementary Data, for a discussion of expected losses to be paid on U.S. RMBS exposures.
Distribution of U.S. RMBS by Rating and Type of Exposure as of December 31, 2014
Ratings: | Prime First Lien | Closed-End Second Lien | HELOC | Alt-A First Lien | Option ARMs | Subprime First Lien | Total Net Par Outstanding | |||||||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||||||
AAA | $ | 1 | $ | — | $ | 8 | $ | 314 | $ | 46 | $ | 1,306 | $ | 1,675 | ||||||||||||||
AA | 84 | 83 | 66 | 361 | 147 | 927 | 1,667 | |||||||||||||||||||||
A | 6 | 0 | — | — | 0 | 107 | 114 | |||||||||||||||||||||
BBB | 28 | — | 107 | 16 | 31 | 136 | 319 | |||||||||||||||||||||
BIG | 353 | 134 | 1,557 | 1,841 | 183 | 1,575 | 5,643 | |||||||||||||||||||||
Total exposures | $ | 472 | $ | 218 | $ | 1,738 | $ | 2,532 | $ | 407 | $ | 4,051 | $ | 9,417 | ||||||||||||||
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Distribution of U.S. RMBS by Year Insured and Type of Exposure as of December 31, 2014
Year insured: | Prime First Lien | Closed End Second Lien | HELOC | Alt-A First Lien | Option ARM | Subprime First Lien | Total Net Par Outstanding | |||||||||||||||||||||
(in millions) | ||||||||||||||||||||||||||||
2004 and prior | $ | 18 | $ | 0 | $ | 149 | $ | 65 | $ | 21 | $ | 1,087 | $ | 1,340 | ||||||||||||||
2005 | 150 | — | 471 | 476 | 40 | 192 | 1,328 | |||||||||||||||||||||
2006 | 81 | 51 | 505 | 290 | 52 | 935 | 1,913 | |||||||||||||||||||||
2007 | 223 | 166 | 614 | 1,263 | 252 | 1,768 | 4,286 | |||||||||||||||||||||
2008 | — | — | — | 438 | 43 | 70 | 550 | |||||||||||||||||||||
Total exposures | $ | 472 | $ | 218 | $ | 1,738 | $ | 2,532 | $ | 407 | $ | 4,051 | $ | 9,417 | ||||||||||||||
Exposures by Reinsurer
Ceded par outstanding represents the portion of insured risk ceded to other reinsurers. Under these relationships, the Company cedes a portion of its insured risk in exchange for a premium paid to the reinsurer. The Company remains primarily liable for all risks it directly underwrites and is required to pay all gross claims. It then seeks reimbursement from the reinsurer for its proportionate share of claims. The Company may be exposed to risk for this exposure if it were required to pay the gross claims and not be able to collect ceded claims from an assuming company experiencing financial distress. A number of the financial guaranty insurers to which the Company has ceded par have experienced financial distress and as a result have been downgraded by the rating agencies. In addition, state insurance regulators have intervened with respect to some of these insurers.
Assumed par outstanding represents the amount of par assumed by the Company from other monolines. Under these relationships, the Company assumes a portion of the ceding company’s insured risk in exchange for a premium. The Company may be exposed to risk in this portfolio in that the Company may be required to pay losses without a corresponding premium in circumstances where the ceding company is experiencing financial distress and is unable to pay premiums.
In addition to assumed and ceded reinsurance arrangements, the Company may also have exposure to some financial guaranty reinsurers (i.e., monolines) in other areas. Second-to-pay insured par outstanding represents transactions the Company has insured that were previously insured by other monolines. The Company underwrites such transactions based on the underlying insured obligation without regard to the primary insurer. See Note 14, Reinsurance and Other Monoline Exposures, of the Financial Statements and Supplementary Data.
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Exposure by Reinsurer
Ratings at | Par Outstanding (1) | |||||||||||||||
February 24, 2015 | As of December 31, 2014 | |||||||||||||||
Reinsurer | Moody’s Reinsurer Rating | S&P Reinsurer Rating | Ceded Par Outstanding | Second-to- Pay Insured Par Outstanding | Assumed Par Outstanding | |||||||||||
(dollars in millions) | ||||||||||||||||
American Overseas Reinsurance Company Limited (f/k/a Ram Re) | WR (2) | WR | $ | 6,727 | $ | — | $ | 30 | ||||||||
Tokio Marine & Nichido Fire Insurance Co., Ltd. | Aa3 (3) | AA- (3) | 5,276 | — | — | |||||||||||
Radian Asset (6) | Ba1 | B+ | 4,104 | 21 | 671 | |||||||||||
Syncora Guarantee Inc. | WR | WR | 3,715 | 1,514 | 161 | |||||||||||
Mitsui Sumitomo Insurance Co. Ltd. | A1 | A+ (3) | 2,033 | — | — | |||||||||||
ACA Financial Guaranty Corp. | NR (5) | WR | 746 | 2 | — | |||||||||||
Swiss Reinsurance Co. | Aa3 | AA- | 93 | — | — | |||||||||||
Ambac Assurance Corporation | WR | WR | 82 | 4,930 | 14,342 | |||||||||||
National Public Finance Guarantee Corporation | A3 | AA- | — | 6,210 | 5,894 | |||||||||||
MBIA | (4) | (4) | — | 2,613 | 587 | |||||||||||
Financial Guaranty Insurance Co. | WR | WR | — | 2,074 | 834 | |||||||||||
Ambac Assurance Corp. Segregated Account | NR | NR | — | 109 | 956 | |||||||||||
CIFG Assurance North America Inc. | WR | WR | — | 102 | 4,365 | |||||||||||
Other | Various | Various | 199 | 894 | 46 | |||||||||||
Total | $ | 22,975 | $ | 18,469 | $ | 27,886 | ||||||||||
____________________
(1) | Includes par related to insured credit derivatives. |
(2) Represents “Withdrawn Rating.”
(3) The Company has structural collateral agreements satisfying the triple-A credit requirement of S&P and/or Moody’s.
(4) | MBIA includes subsidiaries MBIA Insurance Corp. rated B by S&P and B2 by Moody's and MBIA U.K. Insurance Ltd. rated B by S&P and Ba2 by Moody’s. |
(5) | Represents “Not Rated.” |
(6) | On December 22, 2014, the Company entered into an agreement to purchase all of the issued and outstanding capital stock of Radian Asset. |
In accordance with U.S. statutory accounting requirements and U.S. insurance laws and regulations, in order for the Company to receive credit for liabilities ceded to reinsurers domiciled outside of the U.S., such reinsurers must secure their liabilities to the Company. All of the unauthorized reinsurers in the table above are required to post collateral for the benefit of the Company in an amount at least equal to the sum of their ceded unearned premium reserve, loss reserves and contingency reserves all calculated on a statutory basis of accounting. In addition, certain authorized reinsurers in the table above post collateral on terms negotiated with the Company. Collateral may be in the form of letters of credit or trust accounts. The total collateral posted by all non-affiliated reinsurers as of December 31, 2014 is approximately $610 million.
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Liquidity and Capital Resources
Liquidity Requirements and Sources
AGL and its Holding Company Subsidiaries
The liquidity of AGL, AGUS and AGMH is largely dependent on dividends from their operating subsidiaries and their access to external financing. The liquidity requirements of these entities include the payment of operating expenses, interest on debt issued by AGUS and AGMH, and dividends on AGL's common shares. AGL and its holding company subsidiaries may also require liquidity to make periodic capital investments in their operating subsidiaries or, in the case of AGL, to repurchase its common shares pursuant to its share repurchase authorization. In the ordinary course of business, the Company evaluates its liquidity needs and capital resources in light of holding company expenses and dividend policy, as well as rating agency considerations. The Company also subjects its cash flow projections and its assets to a stress test, maintaining a liquid asset balance of one time its stressed operating company net cash flows. Management believes that AGL will have sufficient liquidity to satisfy its needs over the next twelve months. See “Insurance Company Regulatory Restrictions” below for a discussion of the dividend restrictions of its insurance company subsidiaries.
AGL and Holding Company Subsidiaries
Significant Cash Flow Items
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Dividends paid by AGC to AGUS | $ | 69 | $ | 67 | $ | 55 | |||||
Dividends paid by AGM to AGMH | 160 | 163 | 30 | ||||||||
Dividends paid by AG Re to AGL | 82 | 144 | 151 | ||||||||
Dividends paid by other subsidiaries to AGMH | 10 | — | — | ||||||||
Repayment of surplus note by AGM to AGMH | 50 | 50 | 50 | ||||||||
Proceeds from issuance of common shares | — | — | 173 | ||||||||
Dividends paid to AGL shareholders | (76 | ) | (75 | ) | (69 | ) | |||||
Repurchases of common shares (1) | (590 | ) | (264 | ) | (24 | ) | |||||
Interest paid | (83 | ) | (70 | ) | (77 | ) | |||||
Acquisition of MAC, net of cash acquired | — | — | (91 | ) | |||||||
Loans from subsidiaries | — | — | 173 | ||||||||
Net proceeds from issuance of long-term debt | 495 | — | — | ||||||||
Payment of long-term debt | — | (7 | ) | (173 | ) | ||||||
____________________
(1) | As of December 31, 2014 and February 26, 2015, on a settlement date basis, the remaining authorization for share repurchases was $210 million and $118 million, respectively. |
Dividends From Subsidiaries
The Company anticipates that for the next twelve months, amounts paid by AGL’s direct and indirect insurance company subsidiaries as dividends or other distributions will be a major source of its liquidity. The insurance company subsidiaries’ ability to pay dividends depends upon their financial condition, results of operations, cash requirements, and compliance with rating agency requirements, and is also subject to restrictions contained in the insurance laws and related regulations of their states of domicile. Dividend restrictions applicable to AGC and AGM, and to AG Re, are described under Note 12, Insurance Company Regulatory Requirements of the Financial Statements and Supplementary Data.
• | Under New York insurance law, AGM may only pay dividends out of "earned surplus", which is the portion of a company's surplus that represents the net earnings, gains or profits (after deduction of all losses) that have not been distributed to shareholders as dividends or transferred to stated capital or capital surplus, or applied to other purposes permitted by law, but does not include unrealized appreciation of assets. AGM may pay dividends without the prior approval of the the New York Superintendent of Financial Services ("New York Superintendent") that, together with all dividends declared or distributed by it during the preceding 12 months, does not exceed the lesser of 10% of its policyholders' surplus (as of the last annual or quarterly statement filed |
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with the New York Superintendent) or 100% of its adjusted net investment income during that period. The maximum amount available during 2015 for AGM to distribute as dividends without regulatory approval after giving effect to dividends paid in the prior 12 months is estimated to be approximately $227 million, of which approximately $67 million is available for distribution in the first quarter of 2015.
• | Under Maryland's insurance law, AGC may, with prior notice to the Maryland Insurance Commissioner, pay an ordinary dividend that, together with all dividends paid in the prior 12 months, does not exceed 10% of its policyholders' surplus (as of the prior December 31) or 100% of its adjusted net investment income during that period. The maximum amount available during 2015 for AGC to distribute as ordinary dividends will be approximately $90 million, of which approximately $21 million is available for distribution in the first quarter of 2015, after giving effect to dividends paid in the prior 12 months. |
• | MAC is a New York domiciled insurance company subject to the same dividend limitations described above for AGM. The Company does not currently anticipate that MAC will distribute any dividends. |
• | Any distribution (including repurchase of shares) of any share capital, contributed surplus or other statutory capital) that would reduce AG Re's total statutory capital by 15% or more of its total statutory capital as set out in its previous year's financial statements requires the prior approval of the Authority. Separately, dividends are paid out of an insurer's statutory surplus and cannot exceed that surplus. Further, annual dividends cannot exceed 25% of total statutory capital and surplus, which is $279 million, without AG Re certifying to the Bermuda Monetary Authority that it will continue to meet required margins. Based on the foregoing limitations, in 2015 AG Re has the capacity to (i) make capital distributions in an aggregate amount up to $127 million without the prior approval of the Authority and (ii) declare and pay dividends in an aggregate amount up to the limit of its outstanding statutory surplus, which is $271 million. Such dividend capacity is further limited by the actual amount of AG Re’s unencumbered assets, which amount changes from time to time due in part to collateral posting requirements. As of December 31, 2014, AG Re had unencumbered assets of approximately $651 million. |
Generally, dividends paid by a U.S. company to a Bermuda holding company are subject to a 30% withholding tax. After AGL became tax resident in the U.K., it became subject to the tax rules applicable to companies resident in the U.K., including the benefits afforded by the U.K.’s tax treaties. The income tax treaty between the U.K. and the U.S. reduces or eliminates the U.S. withholding tax on certain U.S. sourced investment income (to 5% or 0%), including dividends from U.S. subsidiaries to U.K. resident persons entitled to the benefits of the treaty.
External Financing
From time to time, AGL and its subsidiaries have sought external debt or equity financing in order to meet their obligations. External sources of financing may or may not be available to the Company, and if available, the cost of such financing may not be acceptable to the Company.
On June 20, 2014, AGUS issued $500 million of 5.0% Senior Notes due 2014. The notes are guaranteed by AGL. The net proceeds of the notes are being used for general corporate purposes, including the purchase of AGL common shares.
Intercompany Loans
From time to time, AGL and its subsidiaries have entered into intercompany loan facilities. For example, on October 25, 2013, AGL, as borrower, and AGUS, as lender, entered into a revolving credit facility pursuant to which AGL may, from time to time, borrow up to $225 million in the aggregate from AGUS for general corporate purposes. Such commitment terminates on October 25, 2018 (the “loan termination date”). The unpaid principal amount of each loan will bear interest at a fixed rate equal to 100% of the then applicable Federal short-term or mid-term interest rate, as the case may be, as determined under Internal Revenue Code Sec. 1274(d), and interest on all loans will be computed for the actual number of days elapsed on the basis of a year consisting of 360 days. Accrued interest on all loans will be paid on the last day of each June and December, beginning on December 31, 2013, and at maturity. AGL must repay the then unpaid principal amounts of the loans by the third anniversary of the loan termination date. No amounts are currently outstanding under the credit facility.
In addition, in connection with the acquisition of MAC, AGUS entered into a loan agreement with its affiliate Assured Guaranty Re Overseas Ltd. in 2012 to borrow $90 million in order to fund the purchase price. That loan remained outstanding as of December 31, 2014. Furthermore, AGUS obtained the following funds from its subsidiaries in 2012 to complete the remarketing of the $172.5 million principal amount of 8.50% Senior Notes due 2012 that it had issued in 2009 in connection with the acquisition of AGHM: (1) $82.5 million loaned from its affiliate Assured Guaranty (Bermuda) Ltd., (2) $50 million in
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dividends from AGMH, and (3) $40 million in dividends from AGC. The $82.5 million loan was repaid in full in July 2013 with a combination of the outstanding common stock of MAC and cash.
Furthermore, AGL unconditionally guarantees the payment of the principal of, and interest on, the $1,130 million aggregate principal amount of senior notes issued by AGUS and AGMH, and the $450 million aggregate principal amount of junior subordinated debentures issued by AGUS and AGMH, in each case, as described under "Commitments and Contingencies -- Long-Term Debt Obligations " below.
Cash and Investments
As of December 31, 2014, AGL had $126 million in cash and short-term investments with weighted average duration of 0.1 years. AGUS and AGMH had a total of $68 million in cash, short-term investments and other invested assets. In addition, the U.S. holding companies have $183 million in fixed-maturity securities with weighted average duration of 0.8 years.
Insurance Company Subsidiaries
Liquidity of the insurance company subsidiaries is primarily used to pay for:
• | operating expenses, |
• | claims on the insured portfolio, |
• | posting of collateral in connection with credit derivatives and reinsurance transactions, |
• | reinsurance premiums, |
• | dividends to AGL, AGUS and/or AGMH, as applicable, |
• | principal paydown on surplus notes issued, and |
• | capital investments in their own subsidiaries, where appropriate. |
Management believes that, except for the Radian Asset purchase, its subsidiaries’ liquidity needs for the next twelve months can be met from current cash, short-term investments and operating cash flow, including premium collections and coupon payments as well as scheduled maturities and paydowns from their respective investment portfolios. The Company expects to fund the purchase of Radian Asset by AGC primarily through liquidation of securities in the AGC investment portfolio and accumulated cash. The Company targets a balance of its most liquid assets including cash and short-term securities, Treasuries, agency RMBS and pre-refunded municipal bonds equal to 1.5 times its projected operating company cash flow needs over the next four quarters. The Company intends to hold and has the ability to hold temporarily impaired debt securities until the date of anticipated recovery.
Beyond the next twelve months, the ability of the operating subsidiaries to declare and pay dividends may be influenced by a variety of factors, including market conditions, insurance regulations and rating agency capital requirements and general economic conditions.
Insurance policies issued provide, in general, that payments of principal, interest and other amounts insured may not be accelerated by the holder of the obligation. Amounts paid by the Company therefore are typically in accordance with the obligation’s original payment schedule, unless the Company accelerates such payment schedule, at its sole option. CDS may provide for acceleration of amounts due upon the occurrence of certain credit events, subject to single-risk limits specified in the insurance laws of the State of New York. These constraints prohibit or limit acceleration of certain claims according to Article 69 of the New York Insurance Law and serve to reduce the Company’s liquidity requirements.
Payments made in settlement of the Company’s obligations arising from its insured portfolio may, and often do, vary significantly from year-to-year, depending primarily on the frequency and severity of payment defaults and whether the Company chooses to accelerate its payment obligations in order to mitigate future losses.
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Claims (Paid) Recovered
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
U.S. RMBS before benefit for recoveries for breaches of R&W | $ | (304 | ) | $ | (587 | ) | $ | (996 | ) | ||
Net benefit for recoveries for breaches of R&W | 663 | 954 | 459 | ||||||||
U.S. RMBS after benefit for recoveries for breaches of R&W | 359 | 367 | (537 | ) | |||||||
Other structured finance | 2 | (134 | ) | (39 | ) | ||||||
Public finance | (144 | ) | 6 | (303 | ) | ||||||
Other | — | 10 | 12 | ||||||||
Claims (paid) recovered, net of reinsurance(1) | $ | 217 | $ | 249 | $ | (867 | ) | ||||
____________________
(1) | Includes $20 million paid in 2014 and $189 million and $38 million recovered in 2013 and 2012, respectively, for consolidated FG VIEs. Claims recovered in 2013 include invested assets received as part of a restructuring. |
The Company has insured exposure of approximately $3.0 billion to infrastructure transactions with refinancing risk as to which the Company may need to make claim payments that it did not anticipate paying when the policies were issued. Although the Company may not experience ultimate loss on a particular transaction, the aggregate amount of the claim payments may be substantial and reimbursement may not occur for an extended time, if at all. These transactions generally involve long-term infrastructure projects that were financed by bonds that mature prior to the expiration of the project concession. The Company expected the cash flows from these projects to be sufficient to repay all of the debt over the life of the project concession, but also expected the debt to be refinanced in the market at or prior to its maturity. If the issuer is unable to refinance the debt due to market conditions, the Company may have to pay a claim when the debt matures, and then recover its payment from cash flows produced by the project in the future. The Company generally projects that in most scenarios it will be fully reimbursed for such payments. However, the recovery of the payments is uncertain and may take from 10 to 35 years, depending on the transaction and the performance of the underlying collateral. The Company estimates total claims for the two largest transactions with significant refinancing risk, assuming no refinancing, and based on certain performance assumptions could be $1.8 billion on a gross basis; such claims would be payable from 2017 through 2022.
In addition, the Company has net par exposure of $4.9 billion to the Commonwealth of Puerto Rico, of which $4.7 billion net par is rated BIG by the Company. Puerto Rico has experienced significant general fund budget deficits in recent years. These deficits have been covered primarily with the net proceeds of bond issuances, with interim financings provided by GDB and, in some cases, with one-time revenue measures or expense adjustment measures. In addition to high debt levels, Puerto Rico faces a challenging economic environment. Information regarding the Company's exposure to the Commonwealth of Puerto Rico and its related authorities and public corporations is set forth in "Insured Portfolio-Exposure to Puerto Rico" above.
The terms of the Company’s CDS contracts generally are modified from standard CDS contract forms approved by ISDA in order to provide for payments on a scheduled basis and to replicate the terms of a traditional financial guaranty insurance policy. Some contracts the Company entered into as the credit protection seller, however, utilize standard ISDA settlement mechanics of cash settlement (i.e., a process to value the loss of market value of a reference obligation) or physical settlement (i.e., delivery of the reference obligation against payment of principal by the protection seller) in the event of a “credit event,” as defined in the relevant contract. Cash settlement or physical settlement generally requires the payment of a larger amount, prior to the maturity of the reference obligation, than would settlement on a “pay-as-you-go” basis, under which the Company would be required to pay scheduled interest shortfalls during the term of the reference obligation and scheduled principal shortfall only at the final maturity of the reference obligation. In addition, under certain of the Company's CDS, the Company may be obligated to collateralize its obligations under the CDS if it does not maintain financial strength ratings above the negotiated rating level specified in the CDS documentation.
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Consolidated Cash Flows
Consolidated Cash Flow Summary
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
Net cash flows provided by (used in) operating activities before effects of trading securities and FG VIEs consolidation | $ | 431 | $ | 396 | $ | (272 | ) | ||||
(Purchases) sales of trading securities, net | 78 | (16 | ) | (59 | ) | ||||||
Effect of FG VIEs consolidation | 68 | (136 | ) | 166 | |||||||
Net cash flows provided by (used in) operating activities - reported | 577 | 244 | (165 | ) | |||||||
Net cash flows provided by (used in) investing activities before effects of FG VIEs consolidation | (423 | ) | 37 | 387 | |||||||
Effect of FG VIEs consolidation | 327 | 644 | 556 | ||||||||
Net cash flows provided by (used in) investing activities - reported | (96 | ) | 681 | 943 | |||||||
Net cash flows provided by (used in) financing activities before effects of FG VIEs consolidation | (189 | ) | (367 | ) | (132 | ) | |||||
Effect of FG VIEs consolidation | (396 | ) | (511 | ) | (724 | ) | |||||
Net cash flows provided by (used in) financing activities - reported (1) | (585 | ) | (878 | ) | (856 | ) | |||||
Effect of exchange rate changes | (5 | ) | (1 | ) | 1 | ||||||
Cash at beginning of period | 184 | 138 | 215 | ||||||||
Total cash at the end of the period | $ | 75 | $ | 184 | $ | 138 | |||||
____________________
(1) | Claims paid on consolidated FG VIEs are presented in the consolidated cash flow statements as a component of paydowns on FG VIE liabilities in financing activities as opposed to operating activities. |
Excluding net cash flows from purchases and sales of the trading portfolio and the effect of consolidating FG VIEs, cash inflows from operating activities increased in 2014 compared with 2013 due primarily to lower claims paid on losses (net of R&W recoveries) and cash received on commutation agreements, offset in part by (1) lower premiums and realized gains (losses) and other settlements on credit derivatives, net of commissions, (2) higher taxes and (3) interest payments.
Excluding consolidated FG VIEs, cash inflows from operating activities in 2013 compared to cash outflows for 2012 were mainly due to lower claim payments (net of R&W recoveries), partially offset by lower premiums due to lower business production and higher taxes in 2013. Losses paid in 2012 include claims related to Greek sovereign exposures.
Investing activities were primarily net sales (purchases) of fixed-maturity and short-term investment securities. Investing cash flows in 2014, 2013 and 2012 include inflows of $408 million, $663 million and $545 million for FG VIEs, respectively. The 2013 amounts included proceeds from sales of third party surplus notes and other invested assets. In 2012 the Company paid $91 million to acquire MAC and received $56 million from a payment of a note receivable.
Financing activities consisted primarily of paydowns of FG VIE liabilities and share repurchases. Financing cash flows in 2014, 2013 and 2012 include outflows of $396 million, $511 million and $724 million for FG VIEs, respectively. In 2014, the Company paid $590 million to repurchase 24.4 million common shares; in 2013, the Company paid $264 million to repurchase 12.5 million common shares; and in 2012, the Company paid $24 million to repurchase 2.1 million common shares.
As of December 31, 2014, the Company was authorized to repurchase $210 million in common shares. Since the beginning of 2015 and through February 26, 2015, the Company had repurchased an additional 3.6 million shares for $92 million. For more information about the Company's share repurchase authorization and the amounts it repurchased in 2014, see Note 19, Shareholders' Equity, of the Financial Statements and Supplementary Data.
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Commitments and Contingencies
Leases
AGL and its subsidiaries are party to various lease agreements. The principal executive offices of AGL and AG Re consist of approximately 8,250 square feet of office space located in Hamilton, Bermuda; the lease for this space expires in April 2021. The principal place of business of AGM, AGC, MAC and the Company's other U.S. based subsidiaries is located in New York City, where the Company leases approximately 110,000 square feet of office space under an agreement that expires in April 2026. In addition, the Company occupies another approximately 21,000 square feet of office space in London and Sydney, and two offices in San Francisco and Irvine, California. The Company intends to close the Sydney office on March 31, 2015 and the Irvine office on June 30, 2015. See “–Contractual Obligations” for lease payments due by period. Rent expense was $10.1 million in 2014, $9.9 million in 2013 and $10.0 million in 2012.
Long-Term Debt Obligations
The outstanding principal and interest paid on long-term debt were as follows:
Principal Outstanding
and Interest Paid on Long-Term Debt
Principal Amount | Interest Paid | ||||||||||||||||||
As of December 31, | Year Ended December 31, | ||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2012 | |||||||||||||||
(in millions) | |||||||||||||||||||
AGUS: | |||||||||||||||||||
7.0% Senior Notes(1) | $ | 200 | $ | 200 | $ | 14 | $ | 14 | $ | 14 | |||||||||
5.0% Senior Notes(1) | 500 | — | 13 | — | — | ||||||||||||||
8.50% Senior Notes(1)(2) | — | — | — | — | 7 | ||||||||||||||
Series A Enhanced Junior Subordinated Debentures(3) | 150 | 150 | 10 | 10 | 10 | ||||||||||||||
Total AGUS | 850 | 350 | 37 | 24 | 31 | ||||||||||||||
AGMH(4): | |||||||||||||||||||
67/8% QUIBS(1) | 100 | 100 | 7 | 7 | 7 | ||||||||||||||
6.25% Notes(1) | 230 | 230 | 14 | 14 | 14 | ||||||||||||||
5.60% Notes(1) | 100 | 100 | 6 | 6 | 6 | ||||||||||||||
Junior Subordinated Debentures(3) | 300 | 300 | 19 | 19 | 19 | ||||||||||||||
Total AGMH | 730 | 730 | 46 | 46 | 46 | ||||||||||||||
AGM(4): | |||||||||||||||||||
AGM Notes Payable | 16 | 34 | 3 | 6 | 8 | ||||||||||||||
Total AGM | 16 | 34 | 3 | 6 | 8 | ||||||||||||||
Total | $ | 1,596 | $ | 1,114 | $ | 86 | $ | 76 | $ | 85 | |||||||||
____________________
(1) | AGL fully and unconditionally guarantees these obligations |
(2) | On June 1, 2012, AGUS retired all of the 8.5% Senior Notes. See Note 17, Long-Term Debt and Credit Facilities, of the Financial Statements and Supplementary Data. |
(3) | Guaranteed by AGL on a junior subordinated basis. |
(4) Principal amounts vary from carrying amounts due primarily to acquisition method fair value adjustments at the AGMH acquisition date, which are accreted or amortized into interest expense over the remaining terms of these obligations.
7.0% Senior Notes issued by AGUS. On May 18, 2004, AGUS issued $200 million of 7.0% senior notes due 2034 for net proceeds of $197 million. Although the coupon on the Senior Notes is 7.0%, the effective rate is approximately 6.4%, taking into account the effect of a cash flow hedge.
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5.0% Senior Notes issued by AGUS. On June 20, 2014, AGUS issued $500 million of 5.0% Senior Notes due 2024 for net proceeds of $495 million. The notes are guaranteed by AGL. The net proceeds from the sale of the notes are being used for general corporate purposes, including the purchase of common shares of AGL.
Series A Enhanced Junior Subordinated Debentures issued by AGUS. On December 20, 2006, AGUS issued $150 million of the Debentures due 2066. The Debentures pay a fixed 6.40% rate of interest until December 15, 2016, and thereafter pay a floating rate of interest, reset quarterly, at a rate equal to three month London Interbank Offered Rate ("LIBOR") plus a margin equal to 2.38%. AGUS may select at one or more times to defer payment of interest for one or more consecutive periods for up to ten years. Any unpaid interest bears interest at the then applicable rate. AGUS may not defer interest past the maturity date.
6 7/8% QUIBS issued by AGMH. On December 19, 2001, AGMH issued $100 million face amount of 6 7/8% QUIBS due December 15, 2101, which are callable without premium or penalty.
6.25% Notes issued by AGMH. On November 26, 2002, AGMH issued $230 million face amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part.
5.60% Notes issued by AGMH. On July 31, 2003, AGMH issued $100 million face amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part.
Junior Subordinated Debentures issued by AGMH. On November 22, 2006, AGMH issued $300 million face amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, the make-whole redemption price. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. AGMH may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, AGMH entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of AGMH long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by AGMH or any of its subsidiaries on or before the date that is twenty years prior to the final repayment date, except to the extent that AGMH has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of AGMH.
Recourse Credit Facility
In connection with the acquisition of AGMH, AGM agreed to retain the risks relating to the debt and strip policy portions of the leveraged lease business. The liquidity risk to AGM related to the strip policy portion of the leveraged lease business is mitigated by the strip coverage facility described below.
In a leveraged lease transaction, a tax-exempt entity (such as a transit agency) transfers tax benefits to a tax-paying entity by transferring ownership of a depreciable asset, such as subway cars. The tax-exempt entity then leases the asset back from its new owner.
If the lease is terminated early, the tax-exempt entity must make an early termination payment to the lessor. A portion of this early termination payment is funded from monies that were pre-funded and invested at the closing of the leveraged lease transaction (along with earnings on those invested funds). The tax-exempt entity is obligated to pay the remaining, unfunded portion of this early termination payment (known as the “strip coverage”) from its own sources. AGM issued financial guaranty insurance policies (known as “strip policies”) that guaranteed the payment of these unfunded strip coverage amounts to the lessor, in the event that a tax-exempt entity defaulted on its obligation to pay this portion of its early termination payment. AGM can then seek reimbursement of its strip policy payments from the tax-exempt entity, and can also sell the transferred depreciable asset and reimburse itself from the sale proceeds.
Currently, all the leveraged lease transactions in which AGM acts as strip coverage provider are breaching a rating trigger related to AGM and are subject to early termination. However, early termination of a lease does not result in a draw on the AGM policy if the tax-exempt entity makes the required termination payment.If all the leases were to terminate early and the tax-exempt entities do not make the required early termination payments, then AGM would be exposed to possible liquidity
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claims on gross exposure of approximately $1.2 billion as of December 31, 2014. To date, none of the leveraged lease transactions that involve AGM has experienced an early termination due to a lease default and a claim on the AGM policy. It is difficult to determine the probability that AGM will have to pay strip provider claims or the likely aggregate amount of such claims. At December 31, 2014, approximately $1.4 billion of cumulative strip par exposure had been terminated since 2008 on a consensual basis. The consensual terminations have resulted in no claims on AGM.
On July 1, 2009, AGM and Dexia Crédit Local S.A., acting through its New York Branch (“Dexia Crédit Local (NY)”), entered into a credit facility (the “Strip Coverage Facility”). Under the Strip Coverage Facility, Dexia Crédit Local (NY) agreed to make loans to AGM to finance all draws made by lessors on AGM strip policies that were outstanding as of November 13, 2008, up to the commitment amount. The commitment amount of the Strip Coverage Facility was $1 billion at closing of the Company's acquisition of AGMH. AGM has reduced the maximum commitment amount from time to time, after taking into account its experience with its exposure to leveraged lease transactions. Most recently, as of June 30, 2014, AGM reduced the maximum commitment amount to $495 million and agreed with Dexia Crédit Local (NY) that the commitment amount would no longer amortize on a scheduled monthly basis.
Fundings under this facility are subject to certain conditions precedent, and their repayment is collateralized by a security interest that AGM granted to Dexia Crédit Local (NY) in amounts that AGM recovers – from the tax-
exempt entity, or from asset sale proceeds – following its payment of strip policy claims. On June 30, 2014, AGM and Dexia Crédit Local (NY) agreed to shorten the duration of the facility. Accordingly, the Strip Coverage Facility will terminate upon the earliest to occur of an AGM change of control, the reduction of the commitment amount to $0 in accordance with the terms of the facility, and June 30, 2024 (rather than the original maturity date of January 31, 2042).
The Strip Coverage Facility’s financial covenants require that AGM and its subsidiaries maintain:
• | a maximum debt-to-capital ratio of 30%; and |
• | a minimum net worth of 75% of consolidated net worth as of July 1, 2009, plus, beginning June 30, 2015 and on each anniversary of such date, an amount equal to the product of (i) 25% of the aggregate consolidated net income (or loss) for the period beginning July 2, 2009 and ending on June 30, 2014 and (ii) a fraction, the numerator of which is the commitment amount as of the relevant calculation date and the denominator of which is $1 billion. |
The Company was in compliance with all financial covenants as of December 31, 2014.
The Strip Coverage Facility contains restrictions on AGM, including, among other things, in respect of its ability to incur debt, permit liens, pay dividends or make distributions, dissolve or become party to a merger or consolidation. Most of these restrictions are subject to exceptions. The Strip Coverage Facility has customary events of default, including (subject to certain materiality thresholds and grace periods) payment default, bankruptcy or insolvency proceedings and cross-default to other debt agreements.
As of December 31, 2014, no amounts were outstanding under this facility, nor have there been any borrowings during the life of this facility.
Committed Capital Securities
Each of AGC and AGM have issued $200 million of CCS pursuant to transactions in which AGC CCS or AGM’s Committed Preferred Trust Securities (the “AGM CPS”), as applicable, were issued by custodial trusts created for the primary purpose of issuing such securities, investing the proceeds in high-quality assets and providing put options to AGC or AGM, as applicable. The put options allow AGC and AGM to issue non-cumulative redeemable perpetual preferred securities to the trusts in exchange for cash. For both AGC and AGM, four initial trusts were created, each with an initial aggregate face amount of $50 million. The Company does not consider itself to be the primary beneficiary of the trusts for either the AGC or AGM committed capital securities and the trusts are not consolidated in Assured Guaranty's financial statements.
The trusts provide AGC and AGM access to new capital at their respective sole discretion through the exercise of the put options. Upon AGC's or AGM's exercise of its put option, the relevant trust will liquidate its portfolio of eligible assets and use the proceeds to purchase the AGC or AGM preferred stock, as applicable. AGC or AGM may use the proceeds from such sale of its preferred stock to the trusts for any purpose, including the payment of claims. The put agreements have no scheduled termination date or maturity. However, each put agreement will terminate if (subject to certain grace periods) in the event specified events occur.
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AGC Committed Capital Securities. AGC entered into separate put agreements with four custodial trusts with respect to its committed capital securities in April 2005. The AGC put options have not been exercised through the date of this filing. Initially, all of AGC committed capital securities were issued to a special purpose pass-through trust (the “Pass-Through Trust”). The Pass-Through Trust was dissolved in April 2008 and the AGC committed capital securities were distributed to the holders of the Pass-Through Trust's securities. Neither the Pass-Through Trust nor the custodial trusts are consolidated in the Company's financial statements. Income distributions on the Pass-Through Trust securities and committed capital securities were equal to an annualized rate of one-month LIBOR plus 110 basis points for all periods ending on or prior to April 8, 2008. Following dissolution of the Pass-Through Trust, distributions on the AGC committed capital securities are determined pursuant to an auction process. On April 7, 2008 this auction process failed, thereby increasing the annualized rate on the AGC committed capital securities to one-month LIBOR plus 250 basis points. Distributions on the AGC preferred stock will be determined pursuant to the same process. AGC continues to have the ability to exercise its put option and cause the related trusts to purchase AGC Preferred Stock.
AGM Committed Capital Securities. AGM entered into separate put agreements with four custodial trusts with respect to its committed capital securities in June 2003. The AGM put options have not been exercised through the date of this filing. AGM pays a floating put premium to the trusts, which represents the difference between the commercial paper yield and the winning auction rate (plus all fees and expenses of the trust). If an auction does not attract sufficient clearing bids, however, the auction rate is subject to a maximum rate of one-month LIBOR plus 200 basis points for the next succeeding distribution period. Beginning in August 2007, the AGM committed capital securities required the maximum rate for each of the relevant trusts. AGM continues to have the ability to exercise its put option and cause the related trusts to purchase AGM Preferred Stock.
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Contractual Obligations
The following table summarizes the Company's obligations under its contracts, including debt and lease obligations, and also includes estimated claim payments, based on its loss estimation process, under financial guaranty policies it has issued.
As of December 31, 2014 | |||||||||||||||||||
Less Than 1 Year | 1-3 Years | 3-5 Years | After 5 Years | Total | |||||||||||||||
(in millions) | |||||||||||||||||||
Long-term debt: | |||||||||||||||||||
7.0% Senior Notes | $ | 14 | $ | 28 | $ | 28 | $ | 401 | $ | 471 | |||||||||
5.0% Senior Notes | 25 | 50 | 50 | 613 | 738 | ||||||||||||||
Series A Enhanced Junior Subordinated Debentures | 10 | 19 | 19 | 601 | 649 | ||||||||||||||
67/8% QUIBS | 7 | 14 | 14 | 664 | 699 | ||||||||||||||
6.25% Notes | 14 | 29 | 29 | 1,422 | 1,494 | ||||||||||||||
5.60% Notes | 6 | 11 | 11 | 568 | 596 | ||||||||||||||
Junior Subordinated Debentures | 19 | 38 | 38 | 1,202 | 1,297 | ||||||||||||||
Notes Payable | 8 | 7 | 2 | — | 17 | ||||||||||||||
Operating lease obligations(1) | 8 | 16 | 16 | 50 | 90 | ||||||||||||||
Other compensation plans(3) | 16 | — | — | — | 16 | ||||||||||||||
Estimated financial guaranty claim payments(2) | 231 | 957 | 714 | 708 | 2,610 | ||||||||||||||
Total | $ | 358 | $ | 1,169 | $ | 921 | $ | 6,229 | $ | 8,677 | |||||||||
____________________
(1) | Operating lease obligations exclude escalations in building operating costs and real estate taxes. |
(2) | Financial guaranty claim payments represent estimated undiscounted expected cash outflows under direct and assumed financial guaranty contracts, whether accounted for as insurance or credit derivatives, including claim payments under contracts in consolidated FG VIEs. The amounts presented are not reduced for cessions under reinsurance contracts. Amounts include any benefit anticipated from excess spread or other recoveries within the contracts but do not reflect any benefit for recoveries under breaches of R&W. |
(3) | Amount excludes approximately $54 million of liabilities under various supplemental retirement plans, which are fair valued and payable at the time of termination of employment by either employer or employee. Amount also excludes approximately $76 million of liabilities under AGL 2004 long term incentive plan, which are fair valued and payable at the time of termination of employment by either employer or employee. Given the nature of these awards, we are unable to determine the year in which they will be paid. |
Investment Portfolio
The Company’s principal objectives in managing its investment portfolio are to support the highest possible ratings for each operating company; to manage investment risk within the context of the underlying portfolio of insurance risk; to maintain sufficient liquidity to cover unexpected stress in the insurance portfolio; and to maximize after-tax net investment income.
Fixed-Maturity Securities and Short-Term Investments
The Company’s fixed-maturity securities and short-term investments had a duration of 5.0 years as of December 31, 2014 and 4.9 years as of December 31, 2013. Generally, the Company’s fixed-maturity securities are designated as available-for-sale. For more information about the Investment Portfolio and a detailed description of the Company’s valuation of investments see Note 11, Investments and Cash, of the Financial Statements and Supplementary Data.
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Fixed-Maturity Securities and Short-Term Investments
by Security Type
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||
Amortized Cost | Estimated Fair Value | Amortized Cost | Estimated Fair Value | ||||||||||||
(in millions) | |||||||||||||||
Fixed-maturity securities: | |||||||||||||||
Obligations of state and political subdivisions | $ | 5,416 | $ | 5,795 | $ | 4,899 | $ | 5,079 | |||||||
U.S. government and agencies | 635 | 665 | 674 | 700 | |||||||||||
Corporate securities | 1,320 | 1,368 | 1,314 | 1,340 | |||||||||||
Mortgage-backed securities(1): | |||||||||||||||
RMBS | 1,255 | 1,285 | 1,160 | 1,122 | |||||||||||
CMBS | 639 | 659 | 536 | 549 | |||||||||||
Asset-backed securities | 411 | 417 | 605 | 608 | |||||||||||
Foreign government securities | 296 | 302 | 300 | 313 | |||||||||||
Total fixed-maturity securities | 9,972 | 10,491 | 9,488 | 9,711 | |||||||||||
Short-term investments | 767 | 767 | 904 | 904 | |||||||||||
Total fixed-maturity and short-term investments | $ | 10,739 | $ | 11,258 | $ | 10,392 | $ | 10,615 | |||||||
____________________
(1) | Government-agency obligations were approximately 44% of mortgage backed securities as of December 31, 2014 and 50% as of December 31, 2013, based on fair value. |
The following tables summarize, for all fixed-maturity securities in an unrealized loss position as of December 31, 2014 and December 31, 2013, the aggregate fair value and gross unrealized loss by length of time the amounts have continuously been in an unrealized loss position.
Fixed-Maturity Securities
Gross Unrealized Loss by Length of Time
As of December 31, 2014
Less than 12 months | 12 months or more | Total | |||||||||||||||||||||
Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | ||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||
Obligations of state and political subdivisions | $ | 64 | $ | 0 | $ | 25 | $ | (1 | ) | $ | 89 | $ | (1 | ) | |||||||||
U.S. government and agencies | 139 | 0 | 68 | (1 | ) | 207 | (1 | ) | |||||||||||||||
Corporate securities | 189 | (3 | ) | 104 | (2 | ) | 293 | (5 | ) | ||||||||||||||
Mortgage-backed securities: | |||||||||||||||||||||||
RMBS | 205 | (3 | ) | 159 | (18 | ) | 364 | (21 | ) | ||||||||||||||
CMBS | 36 | 0 | 19 | 0 | 55 | 0 | |||||||||||||||||
Asset-backed securities | 56 | (2 | ) | 18 | (1 | ) | 74 | (3 | ) | ||||||||||||||
Foreign government securities | 108 | (2 | ) | 0 | 0 | 108 | (2 | ) | |||||||||||||||
Total | $ | 797 | $ | (10 | ) | $ | 393 | $ | (23 | ) | $ | 1,190 | $ | (33 | ) | ||||||||
Number of securities(1) | 125 | 82 | 198 | ||||||||||||||||||||
Number of securities with other-than-temporary impairment | 3 | 7 | 10 | ||||||||||||||||||||
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Fixed-Maturity Securities
Gross Unrealized Loss by Length of Time
As of December 31, 2013
Less than 12 months | 12 months or more | Total | |||||||||||||||||||||
Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | ||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||
Obligations of state and political subdivisions | $ | 781 | $ | (39 | ) | $ | 5 | $ | 0 | $ | 786 | $ | (39 | ) | |||||||||
U.S. government and agencies | 173 | (6 | ) | — | — | 173 | (6 | ) | |||||||||||||||
Corporate securities | 401 | (18 | ) | 3 | 0 | 404 | (18 | ) | |||||||||||||||
Mortgage-backed securities: | |||||||||||||||||||||||
RMBS | 414 | (21 | ) | 186 | (51 | ) | 600 | (72 | ) | ||||||||||||||
CMBS | 121 | (4 | ) | — | — | 121 | (4 | ) | |||||||||||||||
Asset-backed securities | 196 | (2 | ) | 42 | (5 | ) | 238 | (7 | ) | ||||||||||||||
Foreign government securities | 54 | (1 | ) | 1 | 0 | 55 | (1 | ) | |||||||||||||||
Total | $ | 2,140 | $ | (91 | ) | $ | 237 | $ | (56 | ) | $ | 2,377 | $ | (147 | ) | ||||||||
Number of securities | 425 | 33 | 458 | ||||||||||||||||||||
Number of securities with other-than-temporary impairment | 13 | 11 | 24 | ||||||||||||||||||||
___________________
(1) | The number of securities does not add across because of lots of the same securities that have been purchased at different times and appear in both categories above (i.e., Less than 12 months and 12 months or more). If a security appears in both categories, it is counted only once in the Total column. |
Of the securities in an unrealized loss position for 12 months or more as of December 31, 2014, three securities had an unrealized loss greater than 10% of book value. The total unrealized loss for these securities as of December 31, 2014 was $15 million. The Company has determined that the unrealized losses recorded as of December 31, 2014 are yield related and not the result of other-than-temporary impairment.
Changes in interest rates affect the value of the Company’s fixed-maturity portfolio. As interest rates fall, the fair value of fixed-maturity securities generally increases and as interest rates rise, the fair value of fixed-maturity securities generally decreases. The Company’s portfolio of fixed-maturity securities consists primarily of high-quality, liquid instruments.
The amortized cost and estimated fair value of the Company’s available-for-sale fixed-maturity securities, by contractual maturity, are shown 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.
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Distribution of Fixed-Maturity Securities
by Contractual Maturity
As of December 31, 2014
Amortized Cost | Estimated Fair Value | ||||||
(in millions) | |||||||
Due within one year | $ | 111 | $ | 112 | |||
Due after one year through five years | 1,961 | 2,028 | |||||
Due after five years through 10 years | 2,286 | 2,422 | |||||
Due after 10 years | 3,720 | 3,985 | |||||
Mortgage-backed securities: | |||||||
RMBS | 1,255 | 1,285 | |||||
CMBS | 639 | 659 | |||||
Total | $ | 9,972 | $ | 10,491 | |||
The following table summarizes the ratings distributions of the Company’s investment portfolio as of December 31, 2014 and December 31, 2013. Ratings reflect the lower of the Moody’s and S&P classifications, except for bonds purchased for loss mitigation or risk management strategies, which use Assured Guaranty’s internal ratings classifications.
Distribution of
Fixed-Maturity Securities by Rating
Rating | As of December 31, 2014 | As of December 31, 2013 | ||||
AAA | 14.0 | % | 16.5 | % | ||
AA | 60.3 | 57.5 | ||||
A | 17.9 | 17.6 | ||||
BBB | 0.5 | 0.9 | ||||
BIG(1) | 7.3 | 7.5 | ||||
Total | 100.0 | % | 100.0 | % | ||
____________________
(1) | Comprised primarily of loss mitigation and other risk management assets. See Note 11, Investments and Cash, of the Financial Statements and Supplementary Data. |
The investment portfolio contains securities that are either held in trust for the benefit of reinsurers in accordance with statutory requirements, placed on deposit to fulfill state licensing requirements, or otherwise restricted in the amount of $268 million and $396 million as of December 31, 2014 and December 31, 2013, respectively, based on fair value.
The fair value of the Company’s pledged securities to secure its obligations under its CDS exposure totaled $376 million and $677 million as of December 31, 2014 and December 31, 2013, respectively.
Liquidity Arrangements with respect to AGMH’s former Financial Products Business
AGMH’s former financial products segment had been in the business of borrowing funds through the issuance of GICs and medium term notes and reinvesting the proceeds in investments that met AGMH’s investment criteria. The financial products business also included the equity payment undertaking agreement portion of the leveraged lease business, as described further below in “—Leveraged Lease Business.”
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The GIC Business
Until November 2008, AGMH, through its financial products business, offered GICs to municipalities and other market participants. The GICs were issued through AGMH’s non-insurance subsidiaries (the “GIC Issuers”) FSA Capital Management Services LLC, FSA Capital Markets Services LLC and FSA Capital Markets Services (Caymans) Ltd. In return for an initial payment, each GIC entitles its holder to receive the return of the holder’s invested principal plus interest at a specified rate, and to withdraw principal from the GIC as permitted by its terms. AGM insures the GIC Issuer’s payment obligations on all GICs issued by the applicable GIC Issuer.
The proceeds of GICs issued by the GIC Issuers were loaned to AGMH’s former subsidiary FSA Asset Management LLC ("FSAM"). FSAM in turn invested these funds in fixed-income obligations (primarily residential mortgage-backed securities, but also short-term investments, securities issued or guaranteed by U.S. government sponsored agencies, taxable municipal bonds, securities issued by utilities, infrastructure-related securities, collateralized debt obligations, other asset-backed securities and foreign currency denominated securities) (the “FSAM assets”).
Prior to the completion of the Company's acquisition of AGMH from Dexia Holdings Inc., AGMH sold its ownership interest in the GIC Issuers and FSAM to Dexia Holdings Inc. Even though AGMH no longer owns the GIC Issuers or FSAM, AGM’s guarantees of the GICs remain in place, and must remain in place until each GIC is terminated.
In June 2009, in connection with the Company's acquisition of AGMH from Dexia Holdings Inc., Dexia SA, the ultimate parent of Dexia Holdings Inc., and certain of its affiliates, entered into a number of agreements intended to mitigate the credit, interest rate and liquidity risks associated with the GIC business and the related AGM guarantees. Some of those agreements have since terminated or expired, or been modified. In addition to the surviving agreements described below, AGM benefits from a guaranty jointly and severally issued by Dexia SA and Dexia Crédit Local S.A. to AGM that guarantees the payment obligations of AGM under its policies related to the GIC business, and an indemnification agreement between AGM, Dexia SA and Dexia Crédit Local S.A. that protects AGM from other losses arising out of or as a result of the GIC business.
To support the payment obligations of FSAM and the GIC Issuers, each of Dexia SA and Dexia Crédit Local S.A. are party to an ISDA Master Agreement, including an associated schedule, confirmation and credit support annex (the “Non-Guaranteed Put Contract”), the economic effect of which is that Dexia SA and Dexia Crédit Local S.A. jointly and severally guarantee (i) the scheduled payments of interest and principal in relation to a specified portfolio of FSAM assets, (ii) the obligation of certain Dexia affiliates to provide liquidity or liquid collateral under committed liquidity lending facilities, and (iii) the obligation to make certain payments in the event of an insolvency of Dexia S.A. Pursuant to the Non-Guaranteed Put Contract, FSAM may put an amount of FSAM assets to Dexia SA and Dexia Crédit Local S.A. in exchange for funds. The amount that could be put varies depending on the type of trigger event in question. In an asset default scenario, the amount payable generally covers at least the amount of the losses on the FSAM assets (by non-payment, writedown or realized loss). For other trigger events, the amount payable generally is at least the amount due and unpaid under the committed liquidity facilities, the principal amount of the FSAM assets, and the outstanding principal balance of the GICs. Dexia S.A. and Dexia Crédit Local S.A. also benefit from certain grace periods and procedural rights under the Non-Guaranteed Put Contract. To secure the Non-Guaranteed Put Contract, Dexia SA and Dexia Crédit Local S.A. will, pursuant to the credit support annex thereto, post eligible highly liquid collateral having an aggregate value (subject to agreed reductions) equal to at least the excess of (i) the aggregate principal amount of all outstanding GICs over (ii) the aggregate mark-to-market value of FSAM’s assets. The agreed-to advance rates applicable to the value of FSAM assets range from 98% to 82% for obligations backed by the full faith and credit of the United States, sovereign obligations of the U.K., Germany, the Netherlands, France or Belgium, obligations guaranteed by the Federal Deposit Insurance Corporation (FDIC) and for mortgage securities issued or guaranteed by U.S. sponsored agencies, and range from 75% to 0% for the other FSAM assets. As of December 31, 2014, approximately 30.2% of the FSAM assets (measured by aggregate principal balance) was in cash or were obligations backed by the full faith and credit of the United States.
As of December 31, 2014, the aggregate accreted GIC balance was approximately $2.3 billion, compared with approximately $10.2 billion as of December 31, 2009 . As of December 31, 2014, and with respect to the FSAM assets that are covered by the primary put contract, the aggregate accreted principal was approximately $3.4 billion, the aggregate market value was approximately $3.1 billion and the aggregate market value after agreed reductions was approximately $2.3 billion. Cash and positive derivative value exceeded the negative derivative values and other projected costs by approximately $128 million. Accordingly, as of December 31, 2014, the aggregate fair value of the assets supporting the GIC business plus cash and positive derivative value exceeded by nearly $0.9 billion the aggregate principal amount of all outstanding GICs and certain other business and hedging costs of the GIC business. Even after applying the agreed upon reductions to the fair value of the assets, the aggregate fair value of the assets supporting the GIC business plus cash and positive derivative value exceeded the aggregate principal amount of all outstanding GICs and certain other business and hedging costs of the GIC business, so, no
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posting of collateral was required under the credit support annex applicable to the primary put contract. Under the terms of that credit support annex, the collateral posting is recalculated on a weekly basis according to the formula set forth in the credit support annex, and a collateral posting is required whenever the collateralization levels tested by the formula are not satisfied, subject to a threshold of $5 million.
To provide additional support, Dexia affiliates provide liquidity commitments to lend against the FSAM assets, generally until the GICs have been paid in full. The liquidity commitments comprise:
• | an amended and restated revolving credit agreement (the “Liquidity Facility”) pursuant to which Dexia Crédit Local S.A. commits to provide funds to FSAM. As a result of agreed reductions and GIC amortization as of December 31, 2014 the commitments totaled $3.6 billion of (which approximately $1.0 billion was drawn), and |
• | a master repurchase agreement (the “Repurchase Facility Agreement” and, together with the Liquidity Facility, the “Guaranteed Liquidity Facilities”) pursuant to which Dexia Crédit Local S.A. will provide up to $3.5 billion of funds in exchange for the transfer by FSAM to Dexia Crédit Local S.A. of FSAM securities that are not eligible to satisfy collateralization obligations of the GIC Issuers under the GICs. As of December 31, 2014, no amounts were outstanding under the Repurchase Facility Agreement. |
Despite the execution of the Non-Guaranteed Put Contract and the Guaranteed Liquidity Facilities, and the significant portion of FSAM assets comprised of highly liquid securities backed by the full faith and credit of the United States, AGM remains subject to the risk that Dexia SA and its affiliates may not make payments or securities available (i) on a timely basis, which is referred to as “liquidity risk,” or (ii) at all, which is referred to as “credit risk,” because of the risk of default. Even if the Dexia entities have sufficient assets to pay all amounts when due, concerns regarding Dexia’s financial condition or willingness to comply with their obligations could cause one or more rating agencies to view negatively the ability or willingness of Dexia SA and its affiliates to perform under their various agreements and could negatively affect AGM’s ratings.
If Dexia SA or its affiliates do not fulfill the contractual obligations, the GIC issuers may not have the financial ability to pay upon the withdrawal of GIC funds or post collateral or make other payments in respect of the GICs, thereby resulting in claims upon the AGM financial guaranty insurance policies. If AGM is required to pay a claim due to a failure of the GIC issuers to pay amounts in respect of the GICs, AGM is subject to the risk that the GICs will not be paid from funds received from Dexia SA and its affiliates before it is required to make payment under its financial guaranty policies or that it will not receive the guaranty payment at all.
One situation in which AGM may be required to pay claims in respect of AGMH's former financial products business if Dexia SA and its affiliates do not comply with their obligations is following a downgrade of the financial strength rating of AGM. Most of the GICs insured by AGM allow for the withdrawal of GIC funds in the event of a downgrade of AGM, unless the relevant GIC issuer posts collateral or otherwise enhances its credit. Most GICs insured by AGM allow for the termination of the GIC contract and a withdrawal of GIC funds at the option of the GIC holder in the event of a downgrade of AGM below a specified threshold, generally below A- by S&P or A3 by Moody's, with no right of the GIC issuer to avoid such withdrawal by posting collateral or otherwise enhancing its credit. Each GIC contract stipulates the thresholds below which the GIC issuer must post eligible collateral, along with the types of securities eligible for posting and the collateralization percentage applicable to each security type. These collateralization percentages range from 100% of the GIC balance for cash posted as collateral to, typically, 108% for asset-backed securities. There are expected to be sufficient eligible and liquid assets within the GIC business to satisfy any withdrawal and collateral posting obligations that would be expected to arise as a result of potential future rating action affecting AGM.
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The Medium Term Notes Business
In connection with the acquisition of AGMH, Dexia Crédit Local S.A. agreed to fund, on behalf of AGM, 100% of all policy claims made under financial guaranty insurance policies issued by AGM in relation to the medium term notes issuance program of FSA Global Funding Limited. Such agreement is set out in a Separation Agreement, dated as of July 1, 2009, between Dexia Crédit Local S.A., AGM, FSA Global Funding and Premier International Funding Co., and in a funding guaranty and a reimbursement guaranty that Dexia Crédit Local S.A. issued for the benefit of AGM. Under the funding guaranty, Dexia Crédit Local S.A. guarantees to pay to or on behalf of AGM amounts equal to the payments required to be made under policies issued by AGM relating to the medium term notes business. Under the reimbursement guaranty, Dexia Crédit Local S.A. guarantees to pay reimbursement amounts to AGM for payments they make following a claim for payment under an obligation insured by a policy they have issued. Notwithstanding Dexia Crédit Local S.A.’s obligation to fund 100% of all policy claims under those policies, AGM has a separate obligation to remit to Dexia Crédit Local S.A. a certain percentage (ranging from 0% to 25%) of those policy claims. AGM, the Company and related parties are also protected against losses arising out of or as a result of the medium term note business through an indemnification agreement with Dexia Crédit Local S.A. As of December 31, 2014, FSA Global Funding Limited had approximately $1.1 billion of medium term notes outstanding.
Leveraged Lease Business
Under the Strip Coverage Facility entered into in connection with the acquisition of AGMH, Dexia Credit Local (NY) agreed to make loans to AGM to finance all draws made by lessors on certain AGM strip policies issued in connection with the leveraged lease business. AGM may request advances under the Strip Coverage Facility without any explicit limit on the number of loan requests, provided that the aggregate principal amount of loans outstanding as of any date may not initially exceed the commitment amount. The leveraged lease business, the AGM strip policies and the Strip Coverage Facility are described further under “Commitments and Contingencies—Recourse Credit Facility” above.
ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
Market risk is the risk of adverse changes in earnings, cash flow or fair value as a result of changes in the value of financial instruments. The Company's primary market risk exposures include interest rate risk, foreign currency exchange rate risk and credit spread risk. The Company's primary exposure to market risk is summarized below:
• | The fair value of credit derivatives within the financial guaranty portfolio of insured obligations which fluctuate based on changes in credit spreads of the underlying obligations and the Company's own credit spreads. |
• | The Investment Portfolio's fair value is primarily driven by changes in interest rates and also affected by changes in credit spreads. |
• | The Investment Portfolio also contains foreign denominated securities whose value fluctuates based on changes in foreign exchange rates. |
• | Premiums receivable include foreign denominated receivables whose carrying value fluctuates based on changes in foreign exchange rates. |
• | The fair value of the assets and liabilities of consolidated FG VIE's may fluctuate based on changes in prepayment spreads, default rates, interest rates, and house price depreciation/appreciation. |
Sensitivity of Credit Derivatives to Credit Risk
Unrealized gains and losses on credit derivatives are a function of changes in the estimated fair value of the Company's credit derivative contracts. If credit spreads of the underlying obligations change, the fair value of the related credit derivative changes. Market liquidity could also impact valuations of the underlying obligations. The Company considers the impact of its own credit risk, together with credit spreads on the risk that it insured through CDS contracts, in determining their fair value. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date. The quoted price of CDS contracts traded on AGC at December 31, 2014 and December 31, 2013 was 323 bps and 460 bps, respectively. The quoted price of CDS contracts traded on AGM at December 31, 2014 and December 31, 2013 was 325 bps and 525 bps, respectively. Historically, the price of CDS traded on AGC and AGM moves directionally the same as general market spreads, although this may not always be the case. An overall narrowing of spreads generally results in an unrealized gain on credit derivatives for the Company, and an overall widening of spreads generally results in an unrealized
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loss for the Company. In certain circumstances, due to the fact that spread movements are not perfectly correlated, the narrowing or widening of the price of CDS traded on AGC and AGM can have a more significant financial statement impact than the changes in underlying collateral prices.
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company's own credit cost, based on the price to purchase credit protection on AGC and AGM.
The Company generally holds these credit derivative contracts to maturity. The unrealized gains and losses on derivative financial instruments will reduce to zero as the exposure approaches its maturity date, unless there is a payment default on the exposure or early termination. Given these facts, the Company does not actively hedge these exposures.
The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads on AGC and AGM and on the risks that they both assume.
Effect of Changes in Credit Spread
As of December 31, 2014 | As of December 31, 2013 | |||||||||||||||
Credit Spreads(1) | Estimated Net Fair Value (Pre-Tax) | Estimated Change in Gain/(Loss) (Pre-Tax) | Estimated Net Fair Value (Pre-Tax) | Estimated Change in Gain/(Loss) (Pre-Tax) | ||||||||||||
(in millions) | ||||||||||||||||
100% widening in spreads | $ | (1,821 | ) | $ | (926 | ) | $ | (3,499 | ) | $ | (1,806 | ) | ||||
50% widening in spreads | (1,358 | ) | (463 | ) | (2,596 | ) | (903 | ) | ||||||||
25% widening in spreads | (1,128 | ) | (233 | ) | (2,145 | ) | (452 | ) | ||||||||
10% widening in spreads | (989 | ) | (94 | ) | (1,874 | ) | (181 | ) | ||||||||
Base Scenario | (895 | ) | — | (1,693 | ) | — | ||||||||||
10% narrowing in spreads | (809 | ) | 86 | (1,527 | ) | 166 | ||||||||||
25% narrowing in spreads | (679 | ) | 216 | (1,276 | ) | 417 | ||||||||||
50% narrowing in spreads | (466 | ) | 429 | (860 | ) | 833 | ||||||||||
____________________
(1) | Includes the effects of spreads on both the underlying asset classes and the Company's own credit spread. |
Sensitivity of Investment Portfolio to Interest Rate Risk
Interest rate risk is the risk that financial instruments' values will change due to changes in the level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. The Company is exposed to interest rate risk primarily in its investment portfolio. As interest rates rise for an available-for-sale investment portfolio, the fair value of fixed‑income securities decreases. The Company's policy is generally to hold assets in the investment portfolio to maturity. Therefore, barring credit deterioration, interest rate movements do not result in realized gains or losses unless assets are sold prior to maturity. The Company does not hedge interest rate risk, however, interest rate fluctuation risk is managed through the investment guidelines which limit duration and prevent investment in high volatility sectors.
Interest rate sensitivity in the investment portfolio can be estimated by projecting a hypothetical instantaneous increase or decrease in interest rates. The following table presents the estimated pre-tax change in fair value of the Company's fixed-maturity securities and short-term investments from instantaneous parallel shifts in interest rates.
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Sensitivity to Change in Interest Rates on the Investment Portfolio
Increase (Decrease) in Fair Value from Changes in Interest Rates | |||||||||||||||||||||||
300 Basis Point Decrease | 200 Basis Point Decrease | 100 Basis Point Decrease | 100 Basis Point Increase | 200 Basis Point Increase | 300 Basis Point Increase | ||||||||||||||||||
(in millions) | |||||||||||||||||||||||
December 31, 2014 | $ | 1,294 | $ | 942 | $ | 496 | $ | (509 | ) | $ | (1,016 | ) | $ | (1,514 | ) | ||||||||
December 31, 2013 | 953 | 768 | 446 | (499 | ) | (984 | ) | (1,434 | ) | ||||||||||||||
Sensitivity of Other Areas to Interest Rate Risk
Fluctuation in interest rates also affects the demand for the Company's product. When interest rates are lower or when the market is otherwise relatively less risk averse, the spread between insured and uninsured obligations typically narrows and, as a result, financial guaranty insurance typically provides lower cost savings to issuers than it would during periods of relatively wider spreads. These lower cost savings generally lead to a corresponding decrease in demand and premiums obtainable for financial guaranty insurance. Changes in interest rates also impact the amount of our losses and could impact the amount of infrastructure exposures that can be refinanced in the future. In addition, increases in prevailing interest rate levels can lead to a decreased volume of capital markets activity and, correspondingly, a decreased volume of insured transactions.
In addition, fluctuations in interest rates also impact the amount of excess spread within the RMBS portfolio. Periodic excess spread is created when a trust’s assets produce interest that exceeds the amount required to pay interest on the trust’s liabilities. There are several RMBS transactions in our portfolio which benefit from excess spread either by covering losses in a particular period, or reimbursing past claims under our policies. As of December 31, 2014, the Company projects approximately $250 million of excess spread for all of its RMBS transactions over their remaining lives.
Since excess spread is determined by the relationship between interest rates on the underlying collateral and the trust’s certificates, it can be affected by unmatched moves in either of these interest rates. Additionally, faster than expected prepayments can decrease the dollar amount of excess spread and therefore reduce the cash flow available to cover losses or reimburse past claims. Further, modifications to underlying mortgage rates (e.g. rate reductions for troubled borrowers) can reduce excess spread since there would be no equivalent decrease in the certificate interest rates of the trust's certificates. Similarly, an upswing in short-term rates that increases the trust’s certificate interest rate that is not met with equal increases to the interest rates on the underlying mortgages can decrease excess spread. These potential reductions in excess spread are mitigated by an interest rate cap, which goes into effect once the collateral rate falls below the stated certificate rate. Most transactions, and our guarantees of those transactions, are capped at the collateral rate. The Company is not obligated to pay additional claims because the collateral interest rate drops below the trust's certificate interest rate, rather this just causes the Company to lose the benefit of potential positive excess spread.
Sensitivity of Investment Portfolio to Foreign Exchange Rate Risk
Foreign exchange risk is the risk that a financial instrument's value will change due to a change in the foreign currency exchange rates. The Company has foreign denominated securities in its investment portfolio. Securities denominated in currencies other than U.S. Dollar were 4.0% and 4.0% of the fixed-maturity securities and short-term investments as of December 31, 2014 and 2013, respectively. The Company's material exposure is to changes in the dollar/pound sterling exchange rate. Changes in fair value of available-for-sale investments attributable to changes in foreign exchange rates are recorded in other comprehensive income.
Sensitivity to Change in Foreign Exchange Rates on the Investment Portfolio
Increase (Decrease) in Fair Value from Changes in Foreign Exchange Rates | |||||||||||||||||||||||
30% Decrease | 20% Decrease | 10% Decrease | 10% Increase | 20% Increase | 30% Increase | ||||||||||||||||||
(in millions) | |||||||||||||||||||||||
December 31, 2014 | $ | (135 | ) | $ | (90 | ) | $ | (45 | ) | $ | 45 | $ | 90 | $ | 135 | ||||||||
December 31, 2013 | (131 | ) | (87 | ) | (44 | ) | 44 | 87 | 131 | ||||||||||||||
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Sensitivity of Premiums Receivable to Foreign Exchange Rate Risk
The Company has foreign denominated premium receivables. The Company's material exposure is to changes in dollar/Pound Sterling and dollar/Euro exchange rates.
Sensitivity to Change in Foreign Exchange Rates
on Premium Receivable, Net of Reinsurance
Increase (Decrease) in Premium Receivable from Changes in Foreign Exchange Rates | |||||||||||||||||||||||
30% Decrease | 20% Decrease | 10% Decrease | 10% Increase | 20% Increase | 30% Increase | ||||||||||||||||||
(in millions) | |||||||||||||||||||||||
December 31, 2014 | $ | (95 | ) | $ | (63 | ) | $ | (32 | ) | $ | 32 | $ | 63 | $ | 95 | ||||||||
December 31, 2013 | (108 | ) | (72 | ) | (36 | ) | 36 | 72 | 108 | ||||||||||||||
Sensitivity of FG VIE Assets and Liabilities to Market Risk
The fair value of the Company's FG VIE assets is sensitive to changes relating to estimated prepayment speeds; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); recoveries from excess spread, discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. Significant changes to any of these inputs could materially change the market value of the FG VIE's assets and the implied collateral losses within the transaction. In general the fair value of the FG VIE assets is most sensitive to changes in the projected collateral losses, where an increase in collateral losses typically leads to a decrease in the fair value of the Company's FG VIE assets, while a decrease in collateral losses typically leads to an increase in the fair value of the Company's FG VIE assets. These factors also directly impact the fair value of the Company's FG VIE liabilities.
The fair value of the Company's FG VIE liabilities is also sensitive to changes relating to estimated prepayment speeds; market values of the assets that collateralize the securities; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); recoveries from excess spread, discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. In addition, the Company's FG VIE liabilities with recourse are also sensitive to changes to the Company's implied credit worthiness. Significant changes to any of these inputs could materially change the timing of expected losses within the insured transaction which is a significant factor in determining the implied benefit from the Company's insurance policy guaranteeing the timely payment of principal and interest for the FG VIE tranches insured by the Company. In general, when the timing of expected loss payments by the Company is extended into the future, this typically leads to a decrease in the value of the Company's insurance and a decrease in the fair value of the Company's FG VIE liabilities with recourse, while a shortening of the timing of expected loss payments by the Company typically leads to an increase in the value of the Company's insurance and an increase in the fair value of the Company's FG VIE liabilities with recourse.
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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Assured Guaranty Ltd.:
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, of comprehensive income, of shareholders’ equity and of cash flows present fairly, in all material respects, the financial position of Assured Guaranty Ltd. and its subsidiaries at December 31, 2014 and December 31, 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in the 2013 Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ PricewaterhouseCoopers LLP
New York, New York
February 26, 2015
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Assured Guaranty Ltd.
Consolidated Balance Sheets
(dollars in millions except per share and share amounts)
As of December 31, 2014 | As of December 31, 2013 | ||||||
Assets | |||||||
Investment portfolio: | |||||||
Fixed-maturity securities, available-for-sale, at fair value (amortized cost of $9,972 and $9,488) | $ | 10,491 | $ | 9,711 | |||
Short-term investments, at fair value | 767 | 904 | |||||
Other invested assets | 126 | 170 | |||||
Total investment portfolio | 11,384 | 10,785 | |||||
Cash | 75 | 184 | |||||
Premiums receivable, net of commissions payable | 729 | 876 | |||||
Ceded unearned premium reserve | 381 | 452 | |||||
Deferred acquisition costs | 121 | 124 | |||||
Reinsurance recoverable on unpaid losses | 78 | 36 | |||||
Salvage and subrogation recoverable | 151 | 174 | |||||
Credit derivative assets | 68 | 94 | |||||
Deferred tax asset, net | 260 | 688 | |||||
Financial guaranty variable interest entities’ assets, at fair value | 1,402 | 2,565 | |||||
Other assets | 276 | 309 | |||||
Total assets | $ | 14,925 | $ | 16,287 | |||
Liabilities and shareholders’ equity | |||||||
Unearned premium reserve | $ | 4,261 | $ | 4,595 | |||
Loss and loss adjustment expense reserve | 799 | 592 | |||||
Reinsurance balances payable, net | 107 | 148 | |||||
Long-term debt | 1,303 | 816 | |||||
Credit derivative liabilities | 963 | 1,787 | |||||
Current income tax payable | 5 | 44 | |||||
Financial guaranty variable interest entities’ liabilities with recourse, at fair value | 1,277 | 1,790 | |||||
Financial guaranty variable interest entities’ liabilities without recourse, at fair value | 142 | 1,081 | |||||
Other liabilities | 310 | 319 | |||||
Total liabilities | 9,167 | 11,172 | |||||
Commitments and contingencies (See Note 16) | |||||||
Common stock ($0.01 par value, 500,000,000 shares authorized; 158,306,661 and 182,177,866 shares issued and outstanding) | 2 | 2 | |||||
Additional paid-in capital | 1,887 | 2,466 | |||||
Retained earnings | 3,494 | 2,482 | |||||
Accumulated other comprehensive income, net of tax of $159 and $71 | 370 | 160 | |||||
Deferred equity compensation (320,193 and 320,193 shares) | 5 | 5 | |||||
Total shareholders’ equity | 5,758 | 5,115 | |||||
Total liabilities and shareholders’ equity | $ | 14,925 | $ | 16,287 | |||
The accompanying notes are an integral part of these consolidated financial statements.
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Assured Guaranty Ltd.
Consolidated Statements of Operations
(dollars in millions except per share amounts)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
Revenues | |||||||||||
Net earned premiums | $ | 570 | $ | 752 | $ | 853 | |||||
Net investment income | 403 | 393 | 404 | ||||||||
Net realized investment gains (losses): | |||||||||||
Other-than-temporary impairment losses | (76 | ) | (32 | ) | (58 | ) | |||||
Less: portion of other-than-temporary impairment loss recognized in other comprehensive income | (1 | ) | 10 | (41 | ) | ||||||
Net impairment loss | (75 | ) | (42 | ) | (17 | ) | |||||
Other net realized investment gains (losses) | 15 | 94 | 18 | ||||||||
Net realized investment gains (losses) | (60 | ) | 52 | 1 | |||||||
Net change in fair value of credit derivatives: | |||||||||||
Realized gains (losses) and other settlements | 23 | (42 | ) | (108 | ) | ||||||
Net unrealized gains (losses) | 800 | 107 | (477 | ) | |||||||
Net change in fair value of credit derivatives | 823 | 65 | (585 | ) | |||||||
Fair value gains (losses) on committed capital securities | (11 | ) | 10 | (18 | ) | ||||||
Fair value gains (losses) on financial guaranty variable interest entities | 255 | 346 | 191 | ||||||||
Other income (loss) | 14 | (10 | ) | 108 | |||||||
Total revenues | 1,994 | 1,608 | 954 | ||||||||
Expenses | |||||||||||
Loss and loss adjustment expenses | 126 | 154 | 504 | ||||||||
Amortization of deferred acquisition costs | 25 | 12 | 14 | ||||||||
Interest expense | 92 | 82 | 92 | ||||||||
Other operating expenses | 220 | 218 | 212 | ||||||||
Total expenses | 463 | 466 | 822 | ||||||||
Income (loss) before income taxes | 1,531 | 1,142 | 132 | ||||||||
Provision (benefit) for income taxes | |||||||||||
Current | 96 | 157 | 57 | ||||||||
Deferred | 347 | 177 | (35 | ) | |||||||
Total provision (benefit) for income taxes | 443 | 334 | 22 | ||||||||
Net income (loss) | $ | 1,088 | $ | 808 | $ | 110 | |||||
Earnings per share: | |||||||||||
Basic | $ | 6.30 | $ | 4.32 | $ | 0.58 | |||||
Diluted | $ | 6.26 | $ | 4.30 | $ | 0.57 | |||||
Dividends per share | $ | 0.44 | $ | 0.40 | $ | 0.36 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
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Assured Guaranty Ltd.
Consolidated Statements of Comprehensive Income
(in millions)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
Net income (loss) | $ | 1,088 | $ | 808 | $ | 110 | |||||
Unrealized holding gains (losses) arising during the period on: | |||||||||||
Investments with no other-than-temporary impairment, net of tax provision (benefit) of $80, $(106) and $56 | 196 | (309 | ) | 148 | |||||||
Investments with other-than-temporary impairment, net of tax provision (benefit) of $(9), $(17) and $(2) | (20 | ) | (35 | ) | (7 | ) | |||||
Unrealized holding gains (losses) arising during the period, net of tax | 176 | (344 | ) | 141 | |||||||
Less: reclassification adjustment for gains (losses) included in net income (loss), net of tax provision (benefit) of $(21), $5 and $(7) | (41 | ) | 14 | (4 | ) | ||||||
Change in net unrealized gains on investments | 217 | (358 | ) | 145 | |||||||
Other, net of tax provision | (7 | ) | 3 | 2 | |||||||
Other comprehensive income (loss) | $ | 210 | $ | (355 | ) | $ | 147 | ||||
Comprehensive income (loss) | $ | 1,298 | $ | 453 | $ | 257 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
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Assured Guaranty Ltd.
Consolidated Statements of Shareholders’ Equity
Years Ended December 31, 2014, 2013 and 2012
(dollars in millions, except share data)
Common Shares Outstanding | Common Stock Par Value | Additional Paid-in Capital | Retained Earnings | Accumulated Other Comprehensive Income | Deferred Equity Compensation | Total Shareholders’ Equity | |||||||||||||||||||||
Balance at December 31, 2011 | 182,235,798 | 2 | 2,570 | 1,708 | 368 | 4 | 4,652 | ||||||||||||||||||||
Net income | — | — | — | 110 | — | — | 110 | ||||||||||||||||||||
Dividends ($0.36 per share) | — | — | — | (69 | ) | — | — | (69 | ) | ||||||||||||||||||
Common stock issuance, net | 13,428,770 | 0 | 173 | — | — | — | 173 | ||||||||||||||||||||
Common stock repurchases | (2,066,759 | ) | 0 | (24 | ) | — | — | — | (24 | ) | |||||||||||||||||
Share-based compensation and other | 405,488 | 0 | 5 | — | — | — | 5 | ||||||||||||||||||||
Other comprehensive income | — | — | — | — | 147 | — | 147 | ||||||||||||||||||||
Balance at December 31, 2012 | 194,003,297 | 2 | 2,724 | 1,749 | 515 | 4 | 4,994 | ||||||||||||||||||||
Net income | — | — | — | 808 | — | — | 808 | ||||||||||||||||||||
Dividends ($0.40 per share) | — | — | — | (75 | ) | — | — | (75 | ) | ||||||||||||||||||
Common stock repurchases | (12,512,759 | ) | 0 | (264 | ) | — | — | — | (264 | ) | |||||||||||||||||
Share-based compensation and other | 687,328 | 0 | 6 | — | — | 1 | 7 | ||||||||||||||||||||
Other comprehensive loss | — | — | — | — | (355 | ) | — | (355 | ) | ||||||||||||||||||
Balance at December 31, 2013 | 182,177,866 | $ | 2 | $ | 2,466 | $ | 2,482 | $ | 160 | $ | 5 | $ | 5,115 | ||||||||||||||
Net income | — | — | — | 1,088 | — | — | 1,088 | ||||||||||||||||||||
Dividends ($0.44 per share) | — | — | — | (76 | ) | — | — | (76 | ) | ||||||||||||||||||
Common stock repurchases | (24,413,781 | ) | 0 | (590 | ) | — | — | — | (590 | ) | |||||||||||||||||
Share-based compensation and other | 542,576 | 0 | 11 | — | — | — | 11 | ||||||||||||||||||||
Other comprehensive loss | — | — | — | — | 210 | — | 210 | ||||||||||||||||||||
Balance at December 31, 2014 | 158,306,661 | $ | 2 | $ | 1,887 | $ | 3,494 | $ | 370 | $ | 5 | $ | 5,758 | ||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
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Assured Guaranty Ltd.
Consolidated Statements of Cash Flows
(in millions)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
Operating Activities: | |||||||||||
Net Income | $ | 1,088 | $ | 808 | $ | 110 | |||||
Adjustments to reconcile net income to net cash flows provided by operating activities: | |||||||||||
Non-cash interest and operating expenses | 23 | 19 | 18 | ||||||||
Net amortization of premium (discount) on investments | (16 | ) | (8 | ) | 8 | ||||||
Provision (benefit) for deferred income taxes | 347 | 177 | (35 | ) | |||||||
Net realized investment losses (gains) | 60 | (52 | ) | (1 | ) | ||||||
Net unrealized losses (gains) on credit derivatives | (800 | ) | (107 | ) | 477 | ||||||
Fair value loss (gains) on committed capital securities | 11 | (10 | ) | 18 | |||||||
Change in deferred acquisition costs | 3 | (8 | ) | 18 | |||||||
Change in premiums receivable, net of commissions payable | 108 | 86 | 48 | ||||||||
Change in ceded unearned premium reserve | 69 | 109 | 141 | ||||||||
Change in unearned premium reserve | (332 | ) | (612 | ) | (749 | ) | |||||
Change in loss and loss adjustment expense reserve, net | 182 | 136 | (258 | ) | |||||||
Change in current income tax | (45 | ) | 30 | 129 | |||||||
Change in financial guaranty variable interest entities' assets and liabilities, net | (170 | ) | (295 | ) | (7 | ) | |||||
(Purchases) sales of trading securities, net | 78 | (16 | ) | (59 | ) | ||||||
Other | (29 | ) | (13 | ) | (23 | ) | |||||
Net cash flows provided by (used in) operating activities | 577 | 244 | (165 | ) | |||||||
Investing activities | |||||||||||
Fixed-maturity securities: | |||||||||||
Purchases | (2,801 | ) | (1,886 | ) | (1,649 | ) | |||||
Sales | 1,251 | 1,029 | 912 | ||||||||
Maturities | 877 | 883 | 1,105 | ||||||||
Net sales (purchases) of short-term investments | 158 | (87 | ) | 29 | |||||||
Net proceeds from paydowns on financial guaranty variable interest entities’ assets | 408 | 663 | 545 | ||||||||
Acquisition of MAC, net of cash acquired | — | — | (91 | ) | |||||||
Other | 11 | 79 | 92 | ||||||||
Net cash flows provided by (used in) investing activities | (96 | ) | 681 | 943 | |||||||
Financing activities | |||||||||||
Proceeds from issuances of common stock | — | — | 173 | ||||||||
Dividends paid | (76 | ) | (75 | ) | (69 | ) | |||||
Repurchases of common stock | (590 | ) | (264 | ) | (24 | ) | |||||
Share activity under option and incentive plans | 1 | (1 | ) | (3 | ) | ||||||
Net paydowns of financial guaranty variable interest entities’ liabilities | (396 | ) | (511 | ) | (724 | ) | |||||
Net proceeds from issuance of long-term debt | 495 | — | — | ||||||||
Repayment of long-term debt | (19 | ) | (27 | ) | (209 | ) | |||||
Net cash flows provided by (used in) financing activities | (585 | ) | (878 | ) | (856 | ) | |||||
Effect of foreign exchange rate changes | (5 | ) | (1 | ) | 1 | ||||||
Increase (decrease) in cash | (109 | ) | 46 | (77 | ) | ||||||
Cash at beginning of period | 184 | 138 | 215 | ||||||||
Cash at end of period | $ | 75 | $ | 184 | $ | 138 | |||||
Supplemental cash flow information | |||||||||||
Cash paid (received) during the period for: | |||||||||||
Income taxes | $ | 122 | $ | 110 | $ | (24 | ) | ||||
Interest | $ | 86 | $ | 76 | $ | 85 | |||||
The accompanying notes are an integral part of these consolidated financial statements.
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Assured Guaranty Ltd.
Notes to Consolidated Financial Statements
December 31, 2014, 2013 and 2012
1. | Business and Basis of Presentation |
Business
Assured Guaranty Ltd. (“AGL” and, together with its subsidiaries, “Assured Guaranty” or the “Company”) is a Bermuda-based holding company that provides, through its operating subsidiaries, credit protection products to the United States (“U.S.”) and international public finance (including infrastructure) and structured finance markets. The Company applies its credit underwriting judgment, risk management skills and capital markets experience to offer financial guaranty insurance that protects holders of debt instruments and other monetary obligations from defaults in scheduled payments. If an obligor defaults on a scheduled payment due on an obligation, including a scheduled principal or interest payment (“Debt Service”), the Company is required under its unconditional and irrevocable financial guaranty to pay the amount of the shortfall to the holder of the obligation. The Company markets its financial guaranty insurance directly to issuers and underwriters of public finance and structured finance securities as well as to investors in such obligations. The Company guarantees obligations issued principally in the U.S. and the United Kingdom ("U.K."), and also guarantees obligations issued in other countries and regions, including Australia and Western Europe.
In the past, the Company sold credit protection by issuing policies that guaranteed payment obligations under credit derivatives, primarily credit default swaps ("CDS"). Financial guaranty contracts accounted for as credit derivatives are generally structured such that the circumstances giving rise to the Company’s obligation to make loss payments are similar to those for financial guaranty insurance contracts. The Company’s credit derivative transactions are governed by International Swaps and Derivative Association, Inc. (“ISDA”) documentation. The Company has not entered into any new CDS in order to sell credit protection since the beginning of 2009, when regulatory guidelines were issued that limited the terms under which such protection could be sold. The capital and margin requirements applicable under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) also contributed to the Company not entering into such new CDS since 2009. The Company actively pursues opportunities to terminate existing CDS, which have the effect of reducing future fair value volatility in income and/or reducing rating agency capital charges.
Basis of Presentation
The consolidated financial statements 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 that are of a normal recurring nature, necessary for a fair statement of the financial condition, results of operations and cash flows of the Company and its consolidated financial guaranty variable interest entities (“FG VIEs”) for the periods presented. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The consolidated financial statements include the accounts of AGL, its direct and indirect subsidiaries, (collectively, the “Subsidiaries”), and its consolidated FG VIEs. Intercompany accounts and transactions between and among all consolidated entities have been eliminated. Certain prior year balances have been reclassified to conform to the current year's presentation.
The Company's principal insurance company subsidiaries are:
• | Assured Guaranty Municipal Corp. ("AGM"), domiciled in New York; |
• | Municipal Assurance Corp. ("MAC"), domiciled in New York; |
• | Assured Guaranty Corp. ("AGC"), domiciled in Maryland; |
• | Assured Guaranty (Europe) Ltd. ("AGE"), organized in the United Kingdom; and |
• | Assured Guaranty Re Ltd. (“AG Re”), domiciled in Bermuda. |
On December 22, 2014, AGC entered into an agreement to purchase all of the issued and outstanding capital stock of Radian Asset Assurance Inc. ("Radian Asset"), a New York domiciled financial guaranty insurer that ceased writing new business in 2008, for $810 million in cash (subject to adjustment for dividends paid and expenses incurred prior to closing). The Company believes that consummation of the acquisition and the subsequent merger of Radian Asset with and into AGC,
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which are expected to be completed in the first half of 2015, will enhance the financial condition of AGC and the Company. As of December 31, 2014, Radian Asset had an insured portfolio of statutory net par outstanding of $10 billion public finance obligations and $8 billion structured finance obligations. As of December 31, 2014, Radian Asset had approximately $1.3 billion of qualified statutory capital.
MAC was purchased from Radian Asset in 2012 for $91 million in cash. Upon acquisition, the Company recorded $16 million in indefinite lived intangible assets, which represented the value of MAC's insurance licenses. MAC commenced underwriting U.S. public finance business in August 2013. MAC is indirectly owned by AGM and AGC. See Note 12, Insurance Company Regulatory Requirements.
The Company’s organizational structure includes various holding companies, two of which—Assured Guaranty US Holdings Inc. (“AGUS”) and Assured Guaranty Municipal Holdings Inc. (“AGMH”) – have public debt outstanding. See Note 17, Long-Term Debt and Credit Facilities.
Significant Accounting Policies
The Company revalues assets, liabilities, revenue and expenses denominated in non-U.S. currencies into U.S. dollars using applicable exchange rates. Gains and losses relating to translating foreign functional currency financial statements for U.S. GAAP reporting are recorded in other comprehensive income (loss) ("OCI"). Gains and losses relating to transactions in foreign denominations in subsidiaries where the functional currency is the U.S. dollar, are reported in the consolidated statement of operations.
The chief operating decision maker manages the operations of the Company at a consolidated level. Therefore, all results of operations are reported as one segment.
Other significant accounting policies are included in the following notes.
Significant Accounting Policies
Premium revenue recognition | Note 4 |
Policy acquisition cost | Note 5 |
Expected loss to be paid (Insurance, Credit Derivatives and FG VIE contracts) | Note 6 |
Loss and loss adjustment expense (Insurance Contracts) | Note 7 |
Fair value measurement | Note 8 |
Credit derivatives (at Fair Value) | Note 9 |
Variable interest entities (at Fair Value) | Note 10 |
Investments and Cash | Note 11 |
Income Taxes | Note 13 |
Earnings per share | Note 18 |
Stock based compensation | Note 20 |
2. | Rating Actions |
When a rating agency assigns a public rating to a financial obligation guaranteed by one of AGL’s insurance company subsidiaries, it generally awards that obligation the same rating it has assigned to the financial strength of the AGL subsidiary that provides the guaranty. Investors in products insured by AGL’s insurance company subsidiaries frequently rely on ratings published by the rating agencies because such ratings influence the trading value of securities and form the basis for many institutions’ investment guidelines as well as individuals’ bond purchase decisions. Therefore, the Company manages its business with the goal of achieving strong financial strength ratings. However, the methodologies and models used by rating agencies differ, presenting conflicting goals that may make it inefficient or impractical to reach the highest rating level. The methodologies and models are not fully transparent, contain subjective elements and data (such as assumptions about future market demand for the Company’s products) and change frequently. Ratings are subject to continuous review and revision or withdrawal at any time. If the financial strength ratings of one (or more) of the Company’s insurance subsidiaries were reduced below current levels, the Company expects it could have adverse effects on the impacted subsidiary's future business opportunities as well as the premiums the impacted subsidiary could charge for its insurance policies.
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In the last several years, Standard & Poor's Ratings Services ("S&P") and Moody's Investors Service, Inc. ("Moody's") have changed, multiple times, their financial strength ratings of the Company's insurance subsidiaries, or changed the outlook on such ratings. More recently, Kroll Bond Rating Agency ("KBRA") has assigned financial strength ratings to some of the Company's insurance subsidiaries. The rating agencies' most recent actions and proposals related to the Company's insurance subsidiaries are:
• | On March 18, 2014, S&P upgraded the financial strength ratings of all of AGL's insurance subsidiaries to AA (stable outlook) from AA- (stable outlook); it affirmed such ratings in a credit analysis issued on July 2, 2014. |
• | On July 2, 2014, Moody's affirmed the ratings of AGL and its subsidiaries, but changed to negative the outlook of the financial strength ratings of AGC and its subsidiary Assured Guaranty (UK) Ltd. ("AGUK"). |
• | On August 4, 2014, KBRA affirmed MAC's AA+ (stable outlook) financial strength rating. |
• | On November 13, 2014, KBRA assigned a financial strength rating of AA+ (stable outlook) to AGM. |
• | On January 20, 2015, Moody's adopted changes to its credit methodology for financial guaranty insurance companies, and on February 18, 2015 Moody's published a credit opinion maintaining its existing ratings of AGL and its subsidiaries under that new methodology. |
There can be no assurance that any of the rating agencies will not take negative action on their financial strength ratings of the Company's insurance subsidiaries in the future.
For a discussion of the effects of rating actions on the Company, see the following:
• | Note 7, Financial Guaranty Insurance Losses |
• | Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives |
• | Note 14, Reinsurance and Other Monoline Exposures |
• | Note 17, Long-Term Debt and Credit Facilities (regarding the impact on the Company's insured leveraged lease transactions) |
3. | Outstanding Exposure |
The Company’s financial guaranty contracts are written in either insurance or credit derivative form, but collectively are considered financial guaranty contracts. The Company seeks to limit its exposure to losses by underwriting obligations that are investment grade at inception, or in the case of restructurings of troubled credits, the Company may underwrite new issuances that one or more of the rating agencies may rate below-investment-grade ("BIG") as part of its loss mitigation strategy. The Company diversifies its insured portfolio across asset classes and, in the structured finance portfolio, maintains rigorous subordination or collateralization requirements. Reinsurance is utilized in order to reduce net exposure to certain insured transactions.
Public finance obligations insured by the Company consist primarily of general obligation bonds supported by the taxing powers of U.S. state or municipal governmental authorities, as well as tax-supported bonds, revenue bonds and other obligations supported by covenants from state or municipal governmental authorities or other municipal obligors to impose and collect fees and charges for public services or specific infrastructure projects. The Company also includes within public finance obligations those obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including utilities, toll roads, health care facilities and government office buildings.
Structured finance obligations insured by the Company are generally issued by special purpose entities, including variable interest entities ("VIEs"), and backed by pools of assets having an ascertainable cash flow or market value or other specialized financial obligations. Some of these VIEs are consolidated as described in Note 10, Consolidated Variable Interest Entities. Unless otherwise specified, the outstanding par and Debt Service amounts presented in this note include outstanding exposures on VIEs whether or not they are consolidated.
Significant Risk Management Activities
The Portfolio Risk Management Committee, which includes members of senior management and senior credit and surveillance officers, sets specific risk policies and limits and is responsible for enterprise risk management, establishing the Company's risk appetite, credit underwriting of new business, surveillance and work-out.
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Surveillance personnel are responsible for monitoring and reporting on all transactions in the insured portfolio. The primary objective of the surveillance process is to monitor trends and changes in transaction credit quality, detect any deterioration in credit quality, and recommend to management such remedial actions as may be necessary or appropriate. All transactions in the insured portfolio are assigned internal credit ratings, and surveillance personnel are responsible for recommending adjustments to those ratings to reflect changes in transaction credit quality.
Work-out personnel are responsible for managing work-out and loss mitigation situations, working with surveillance and legal personnel (as well as outside vendors) as appropriate. They develop strategies for the Company to enforce its contractual rights and remedies and to mitigate its losses, engage in negotiation discussions with transaction participants and, when necessary, manage (along with legal personnel) the Company's litigation proceedings.
Surveillance Categories
The Company segregates its insured portfolio into investment grade and BIG surveillance categories to facilitate the appropriate allocation of resources to monitoring and loss mitigation efforts and to aid in establishing the appropriate cycle for periodic review for each exposure. BIG exposures include all exposures with internal credit ratings below BBB-. The Company’s internal credit ratings are based on internal assessments of the likelihood of default and loss severity in the event of default. Internal credit ratings are expressed on a ratings scale similar to that used by the rating agencies and are generally reflective of an approach similar to that employed by the rating agencies, except that the Company's internal credit ratings focus on future performance rather than lifetime performance.
The Company monitors its investment grade credits to determine whether any new credits need to be internally downgraded to BIG and refreshes its internal credit ratings on individual credits in quarterly, semi-annual or annual cycles based on the Company’s view of the credit’s quality, loss potential, volatility and sector. Ratings on credits in sectors identified as under the most stress or with the most potential volatility are reviewed every quarter. The Company’s credit ratings on assumed credits are based on the Company’s reviews of low-rated credits or credits in volatile sectors, unless such information is not available, in which case, the ceding company’s credit rating of the transactions are used. The Company models the performance of many of its structured finance transactions as part of its periodic internal credit rating review of them. The Company models most assumed residential mortgage-backed security ("RMBS") credits with par above $1 million, as well as certain RMBS credits below that amount.
Credits identified as BIG are subjected to further review to determine the probability of a loss. See Note 6, Expected Loss to be Paid, for additional information. Surveillance personnel then assign each BIG transaction to the appropriate BIG surveillance category based upon whether a future loss is expected and whether a claim has been paid. For surveillance purposes, the Company calculates present value using a constant discount rate of 4.5%-5% depending on the insurance subsidiary. (A risk-free curve rate is used for calculating the expected loss for financial statement measurement purposes.)
More extensive monitoring and intervention is employed for all BIG surveillance categories, with internal credit ratings reviewed quarterly. The Company expects “future losses” on a transaction when the Company believes there is at least a 50% chance that, on a present value basis, it will pay more claims over the future of that transaction than it will have reimbursed. The three BIG categories are:
• | BIG Category 1: Below-investment-grade transactions showing sufficient deterioration to make future losses possible, but for which none are currently expected. |
• | BIG Category 2: Below-investment-grade transactions for which future losses are expected but for which no claims (other than liquidity claims which is a claim that the Company expects to be reimbursed within one year) have yet been paid. |
• | BIG Category 3: Below-investment-grade transactions for which future losses are expected and on which claims (other than liquidity claims) have been paid. |
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Components of Outstanding Exposure
Unless otherwise noted, ratings disclosed herein on the Company's insured portfolio reflect its internal ratings. The Company classifies those portions of risks benefiting from reimbursement obligations collateralized by eligible assets held in trust in acceptable reimbursement structures as the higher of 'AA' or their current internal rating. The Company excludes amounts attributable to loss mitigation securities (unless otherwise indicated) from par and Debt Service outstanding, because it manages such securities as investments and not insurance exposure.
Financial Guaranty
Debt Service Outstanding
Gross Debt Service Outstanding | Net Debt Service Outstanding | ||||||||||||||
December 31, 2014 | December 31, 2013 | December 31, 2014 | December 31, 2013 | ||||||||||||
(in millions) | |||||||||||||||
Public finance | $ | 587,245 | $ | 650,924 | $ | 553,612 | $ | 610,011 | |||||||
Structured finance | 59,477 | 86,456 | 56,010 | 80,524 | |||||||||||
Total financial guaranty | $ | 646,722 | $ | 737,380 | $ | 609,622 | $ | 690,535 | |||||||
In addition to the amounts shown in the table above, the Company’s net mortgage guaranty insurance debt service was approximately $127 million as of December 31, 2014 related to loans originated in Ireland and $152 million as of December 31, 2013 related to loans originated in Ireland and U.K..
Financial Guaranty Portfolio by Internal Rating
As of December 31, 2014
Public Finance U.S. | Public Finance Non-U.S. | Structured Finance U.S | Structured Finance Non-U.S | Total | |||||||||||||||||||||||||||||||
Rating Category | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | |||||||||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||||||||||||
AAA | $ | 4,082 | 1.3 | % | $ | 615 | 2.0 | % | $ | 20,037 | 48.7 | % | $ | 5,409 | 59.6 | % | $ | 30,143 | 7.5 | % | |||||||||||||||
AA | 90,464 | 28.1 | 2,785 | 8.9 | 8,213 | 19.9 | 503 | 5.5 | 101,965 | 25.3 | |||||||||||||||||||||||||
A | 176,298 | 54.7 | 7,192 | 22.9 | 2,940 | 7.1 | 445 | 4.9 | 186,875 | 46.3 | |||||||||||||||||||||||||
BBB | 43,429 | 13.5 | 19,363 | 61.7 | 1,795 | 4.4 | 1,912 | 21.1 | 66,499 | 16.4 | |||||||||||||||||||||||||
BIG | 7,850 | 2.4 | 1,404 | 4.5 | 8,186 | 19.9 | 807 | 8.9 | 18,247 | 4.5 | |||||||||||||||||||||||||
Total net par outstanding (1) | $ | 322,123 | 100.0 | % | $ | 31,359 | 100.0 | % | $ | 41,171 | 100.0 | % | $ | 9,076 | 100.0 | % | $ | 403,729 | 100.0 | % | |||||||||||||||
_____________________
(1) | Excludes $1.3 billion of loss mitigation securities insured and held by the Company as of December 31, 2014, which are primarily in the BIG category. |
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Financial Guaranty Portfolio by Internal Rating
As of December 31, 2013
Public Finance U.S. | Public Finance Non-U.S. | Structured Finance U.S | Structured Finance Non-U.S | Total | |||||||||||||||||||||||||||||||
Rating Category | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | Net Par Outstanding | % | |||||||||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||||||||||||
AAA | $ | 4,998 | 1.4 | % | $ | 1,016 | 3.0 | % | $ | 32,317 | 54.9 | % | $ | 9,684 | 69.1 | % | $ | 48,015 | 10.5 | % | |||||||||||||||
AA | 107,503 | 30.5 | 422 | 1.2 | 9,431 | 16.0 | 577 | 4.1 | 117,933 | 25.7 | |||||||||||||||||||||||||
A | 192,841 | 54.8 | 9,453 | 27.9 | 2,580 | 4.4 | 742 | 5.3 | 205,616 | 44.8 | |||||||||||||||||||||||||
BBB | 37,745 | 10.7 | 21,499 | 63.2 | 3,815 | 6.4 | 1,946 | 13.9 | 65,005 | 14.1 | |||||||||||||||||||||||||
BIG | 9,094 | 2.6 | 1,608 | 4.7 | 10,764 | 18.3 | 1,072 | 7.6 | 22,538 | 4.9 | |||||||||||||||||||||||||
Total net par outstanding (1) | $ | 352,181 | 100.0 | % | $ | 33,998 | 100.0 | % | $ | 58,907 | 100.0 | % | $ | 14,021 | 100.0 | % | $ | 459,107 | 100.0 | % | |||||||||||||||
_____________________
(1) | Excludes $1.2 billion of loss mitigation securities insured and held by the Company as of December 31, 2013, which are primarily in the BIG category. |
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Financial Guaranty Portfolio
by Sector
Gross Par Outstanding | Ceded Par Outstanding | Net Par Outstanding | |||||||||||||||||||||
Sector | As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2014 | As of December 31, 2013 | |||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||
Public finance: | |||||||||||||||||||||||
U.S.: | |||||||||||||||||||||||
General obligation | $ | 144,714 | $ | 160,751 | $ | 4,438 | $ | 5,474 | $ | 140,276 | $ | 155,277 | |||||||||||
Tax backed | 65,600 | 70,552 | 3,075 | 3,728 | 62,525 | 66,824 | |||||||||||||||||
Municipal utilities | 53,471 | 57,893 | 1,381 | 1,569 | 52,090 | 56,324 | |||||||||||||||||
Transportation | 28,914 | 32,514 | 1,091 | 1,684 | 27,823 | 30,830 | |||||||||||||||||
Healthcare | 16,225 | 17,663 | 1,377 | 1,531 | 14,848 | 16,132 | |||||||||||||||||
Higher education | 13,485 | 14,470 | 386 | 399 | 13,099 | 14,071 | |||||||||||||||||
Infrastructure finance | 5,098 | 5,014 | 917 | 900 | 4,181 | 4,114 | |||||||||||||||||
Housing | 2,880 | 3,518 | 101 | 132 | 2,779 | 3,386 | |||||||||||||||||
Investor-owned utilities | 944 | 992 | 0 | 1 | 944 | 991 | |||||||||||||||||
Other public finance—U.S. | 3,575 | 4,249 | 17 | 17 | 3,558 | 4,232 | |||||||||||||||||
Total public finance—U.S. | 334,906 | 367,616 | 12,783 | 15,435 | 322,123 | 352,181 | |||||||||||||||||
Non-U.S.: | |||||||||||||||||||||||
Infrastructure finance | 15,091 | 17,373 | 2,283 | 2,670 | 12,808 | 14,703 | |||||||||||||||||
Regulated utilities | 14,582 | 15,502 | 3,668 | 4,297 | 10,914 | 11,205 | |||||||||||||||||
Pooled infrastructure | 2,565 | 2,754 | 145 | 234 | 2,420 | 2,520 | |||||||||||||||||
Other public finance—non-U.S. | 6,216 | 6,645 | 999 | 1,075 | 5,217 | 5,570 | |||||||||||||||||
Total public finance—non-U.S. | 38,454 | 42,274 | 7,095 | 8,276 | 31,359 | 33,998 | |||||||||||||||||
Total public finance | 373,360 | 409,890 | 19,878 | 23,711 | 353,482 | 386,179 | |||||||||||||||||
Structured finance: | |||||||||||||||||||||||
U.S.: | |||||||||||||||||||||||
Pooled corporate obligations | 21,791 | 32,955 | 1,145 | 1,630 | 20,646 | 31,325 | |||||||||||||||||
RMBS | 10,109 | 14,542 | 692 | 821 | 9,417 | 13,721 | |||||||||||||||||
Insurance securitizations | 3,480 | 3,082 | 47 | 47 | 3,433 | 3,035 | |||||||||||||||||
Financial product | 2,276 | 2,709 | — | — | 2,276 | 2,709 | |||||||||||||||||
Consumer receivables | 2,157 | 2,257 | 58 | 59 | 2,099 | 2,198 | |||||||||||||||||
Commercial mortgage-backed securities ("CMBS") and other commercial real estate related exposures | 1,979 | 3,990 | 22 | 38 | 1,957 | 3,952 | |||||||||||||||||
Commercial receivables | 567 | 918 | 7 | 7 | 560 | 911 | |||||||||||||||||
Structured credit | 71 | 71 | 2 | 2 | 69 | 69 | |||||||||||||||||
Other structured finance—U.S. | 858 | 2,067 | 144 | 1,080 | 714 | 987 | |||||||||||||||||
Total structured finance—U.S. | 43,288 | 62,591 | 2,117 | 3,684 | 41,171 | 58,907 | |||||||||||||||||
Non-U.S.: | |||||||||||||||||||||||
Pooled corporate obligations | 7,439 | 12,232 | 835 | 1,174 | 6,604 | 11,058 | |||||||||||||||||
Commercial receivables | 965 | 1,286 | 21 | 23 | 944 | 1,263 | |||||||||||||||||
RMBS | 893 | 1,296 | 99 | 150 | 794 | 1,146 | |||||||||||||||||
Structured credit | 9 | 197 | — | 21 | 9 | 176 | |||||||||||||||||
Other structured finance—non-U.S. | 750 | 403 | 25 | 25 | 725 | 378 | |||||||||||||||||
Total structured finance—non-U.S. | 10,056 | 15,414 | 980 | 1,393 | 9,076 | 14,021 | |||||||||||||||||
Total structured finance | 53,344 | 78,005 | 3,097 | 5,077 | 50,247 | 72,928 | |||||||||||||||||
Total net par outstanding | $ | 426,704 | $ | 487,895 | $ | 22,975 | $ | 28,788 | $ | 403,729 | $ | 459,107 | |||||||||||
In addition to amounts shown in the tables above, the Company had outstanding commitments to provide guaranties of $276 million for structured finance and $248 million for public finance obligations at December 31, 2014. The structured finance commitments include the unfunded component of pooled corporate and other transactions. The expiration dates for the
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public finance commitments range between January 15, 2015 and February 17, 2017, with $124 million expiring prior to December 31, 2015. The commitments are contingent on the satisfaction of all conditions set forth in them and may expire unused or be canceled at the counterparty’s request. Therefore, the total commitment amount does not necessarily reflect actual future guaranteed amounts.
Actual maturities of insured obligations could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. The expected maturities of structured finance obligations are, in general, considerably shorter than the contractual maturities for such obligations.
Expected Amortization of
Net Par Outstanding
As of December 31, 2014
Public Finance | Structured Finance | Total | |||||||||
(in millions) | |||||||||||
0 to 5 years | $ | 98,431 | $ | 36,482 | $ | 134,913 | |||||
5 to 10 years | 75,279 | 5,454 | 80,733 | ||||||||
10 to 15 years | 67,354 | 2,874 | 70,228 | ||||||||
15 to 20 years | 51,139 | 2,412 | 53,551 | ||||||||
20 years and above | 61,279 | 3,025 | 64,304 | ||||||||
Total net par outstanding | $ | 353,482 | $ | 50,247 | $ | 403,729 | |||||
Components of BIG Portfolio
Components of BIG Net Par Outstanding
(Insurance and Credit Derivative Form)
As of December 31, 2014
BIG Net Par Outstanding | Net Par | ||||||||||||||||||
BIG 1 | BIG 2 | BIG 3 | Total BIG | Outstanding | |||||||||||||||
(in millions) | |||||||||||||||||||
First lien U.S. RMBS: | |||||||||||||||||||
Prime first lien | $ | 68 | $ | 33 | $ | 252 | $ | 353 | $ | 471 | |||||||||
Alt-A first lien | 585 | 531 | 725 | 1,841 | 2,532 | ||||||||||||||
Option ARM | 47 | 18 | 118 | 183 | 407 | ||||||||||||||
Subprime | 156 | 654 | 765 | 1,575 | 4,051 | ||||||||||||||
Second lien U.S. RMBS: | |||||||||||||||||||
Closed-end second lien | — | 19 | 115 | 134 | 218 | ||||||||||||||
Home equity lines of credit (“HELOCs”) | 1,012 | 36 | 509 | 1,557 | 1,738 | ||||||||||||||
Total U.S. RMBS | 1,868 | 1,291 | 2,484 | 5,643 | 9,417 | ||||||||||||||
Trust preferred securities (“TruPS”) | 997 | — | 336 | 1,333 | 4,326 | ||||||||||||||
Other structured finance | 1,021 | 240 | 756 | 2,017 | 36,504 | ||||||||||||||
U.S. public finance | 6,577 | 1,156 | 117 | 7,850 | 322,123 | ||||||||||||||
Non-U.S. public finance | 1,402 | 2 | — | 1,404 | 31,359 | ||||||||||||||
Total | $ | 11,865 | $ | 2,689 | $ | 3,693 | $ | 18,247 | $ | 403,729 | |||||||||
148
Components of BIG Net Par Outstanding
(Insurance and Credit Derivative Form)
As of December 31, 2013
BIG Net Par Outstanding | Net Par | ||||||||||||||||||
BIG 1 | BIG 2 | BIG 3 | Total BIG | Outstanding | |||||||||||||||
(in millions) | |||||||||||||||||||
First lien U.S. RMBS: | |||||||||||||||||||
Prime first lien | $ | 52 | $ | 321 | $ | 30 | $ | 403 | $ | 541 | |||||||||
Alt-A first lien | 656 | 1,137 | 935 | 2,728 | 3,590 | ||||||||||||||
Option ARM | 71 | 60 | 467 | 598 | 937 | ||||||||||||||
Subprime | 297 | 908 | 740 | 1,945 | 6,130 | ||||||||||||||
Second lien U.S. RMBS: | |||||||||||||||||||
Closed-end second lien | 8 | 20 | 118 | 146 | 244 | ||||||||||||||
HELOCs | 1,499 | 20 | 378 | 1,897 | 2,279 | ||||||||||||||
Total U.S. RMBS | 2,583 | 2,466 | 2,668 | 7,717 | 13,721 | ||||||||||||||
TruPS | 1,587 | 135 | — | 1,722 | 4,970 | ||||||||||||||
Other structured finance | 1,367 | 309 | 721 | 2,397 | 54,237 | ||||||||||||||
U.S. public finance | 8,205 | 440 | 449 | 9,094 | 352,181 | ||||||||||||||
Non-U.S. public finance | 1,009 | 599 | — | 1,608 | 33,998 | ||||||||||||||
Total | $ | 14,751 | $ | 3,949 | $ | 3,838 | $ | 22,538 | $ | 459,107 | |||||||||
BIG Net Par Outstanding
and Number of Risks
As of December 31, 2014
Net Par Outstanding | Number of Risks(2) | ||||||||||||||||||||
Description | Financial Guaranty Insurance(1) | Credit Derivative | Total | Financial Guaranty Insurance(1) | Credit Derivative | Total | |||||||||||||||
(dollars in millions) | |||||||||||||||||||||
BIG: | |||||||||||||||||||||
Category 1 | $ | 10,195 | $ | 1,670 | $ | 11,865 | 164 | 18 | 182 | ||||||||||||
Category 2 | 2,135 | 554 | 2,689 | 75 | 14 | 89 | |||||||||||||||
Category 3 | 2,892 | 801 | 3,693 | 119 | 24 | 143 | |||||||||||||||
Total BIG | $ | 15,222 | $ | 3,025 | $ | 18,247 | 358 | 56 | 414 | ||||||||||||
149
BIG Net Par Outstanding
and Number of Risks
As of December 31, 2013
Net Par Outstanding | Number of Risks(2) | ||||||||||||||||||||
Description | Financial Guaranty Insurance(1) | Credit Derivative | Total | Financial Guaranty Insurance(1) | Credit Derivative | Total | |||||||||||||||
(dollars in millions) | |||||||||||||||||||||
BIG: | |||||||||||||||||||||
Category 1 | $ | 12,391 | $ | 2,360 | $ | 14,751 | 185 | 25 | 210 | ||||||||||||
Category 2 | 2,323 | 1,626 | 3,949 | 80 | 21 | 101 | |||||||||||||||
Category 3 | 3,031 | 807 | 3,838 | 119 | 27 | 146 | |||||||||||||||
Total BIG | $ | 17,745 | $ | 4,793 | $ | 22,538 | 384 | 73 | 457 | ||||||||||||
_____________________
(1) Includes net par outstanding for FG VIEs.
(2) | A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making Debt Service payments. |
150
Geographic Distribution of Net Par Outstanding
The Company seeks to maintain a diversified portfolio of insured obligations designed to spread its risk across a number of geographic areas.
Geographic Distribution of
Net Par Outstanding
As of December 31, 2014
Number of Risks | Net Par Outstanding | Percent of Total Net Par Outstanding | |||||||
(dollars in millions) | |||||||||
U.S.: | |||||||||
U.S. Public finance: | |||||||||
California | 1,465 | $ | 50,668 | 12.6 | % | ||||
Pennsylvania | 1,009 | 26,173 | 6.5 | ||||||
New York | 995 | 26,044 | 6.5 | ||||||
Texas | 1,239 | 25,449 | 6.3 | ||||||
Illinois | 830 | 22,825 | 5.7 | ||||||
Florida | 384 | 19,470 | 4.8 | ||||||
New Jersey | 602 | 13,558 | 3.4 | ||||||
Michigan | 668 | 12,739 | 3.2 | ||||||
Georgia | 192 | 8,217 | 2.0 | ||||||
Ohio | 507 | 7,818 | 1.9 | ||||||
Other states and U.S. territories | 4,174 | 109,162 | 27.0 | ||||||
Total U.S. public finance | 12,065 | 322,123 | 79.9 | ||||||
U.S. Structured finance (multiple states) | 839 | 41,171 | 10.2 | ||||||
Total U.S. | 12,904 | 363,294 | 90.1 | ||||||
Non-U.S.: | |||||||||
United Kingdom | 114 | 19,856 | 4.9 | ||||||
Australia | 26 | 4,121 | 1.0 | ||||||
Canada | 10 | 3,526 | 0.9 | ||||||
France | 20 | 2,820 | 0.7 | ||||||
Italy | 9 | 1,501 | 0.4 | ||||||
Other | 78 | 8,611 | 2.0 | ||||||
Total non-U.S. | 257 | 40,435 | 9.9 | ||||||
Total | 13,161 | $ | 403,729 | 100.0 | % | ||||
151
Exposure to the Selected European Countries
Several European countries continue to experience significant economic, fiscal and/or political strains such that the likelihood of default on obligations with a nexus to those countries may be higher than the Company anticipated when such factors did not exist. The European countries where the Company believes heightened uncertainties exist are: Hungary, Italy, Portugal and Spain (collectively, the “Selected European Countries”). The Company is closely monitoring its exposures in the Selected European Countries where it believes heightened uncertainties exist. Previously, the Company had included Ireland on this list but removed it during the third quarter of 2014 because of Ireland's strengthening economic performance and improving prospects; in 2014, Ireland's long-term foreign currency rating was upgraded one notch by S&P (to ‘A-’) and three notches by Moody’s (to ‘Baa1’). The Company’s direct economic exposure to the Selected European Countries (based on par for financial guaranty contracts and notional amount for financial guaranty contracts accounted for as derivatives) is shown in the following table, net of ceded reinsurance.
Net Direct Economic Exposure to Selected European Countries(1)
As of December 31, 2014
Hungary | Italy | Portugal | Spain | Total | |||||||||||||||
(in millions) | |||||||||||||||||||
Sovereign and sub-sovereign exposure: | |||||||||||||||||||
Non-infrastructure public finance(2) | $ | — | $ | 878 | $ | 91 | $ | 239 | $ | 1,208 | |||||||||
Infrastructure finance | 313 | 13 | 11 | 135 | 472 | ||||||||||||||
Total sovereign and sub-sovereign exposure | 313 | 891 | 102 | 374 | 1,680 | ||||||||||||||
Non-sovereign exposure: | |||||||||||||||||||
Regulated utilities | — | 220 | — | — | 220 | ||||||||||||||
RMBS | 186 | 267 | — | — | 453 | ||||||||||||||
Total non-sovereign exposure | 186 | 487 | — | — | 673 | ||||||||||||||
Total | $ | 499 | $ | 1,378 | $ | 102 | $ | 374 | $ | 2,353 | |||||||||
Total BIG (See Note 6) | $ | 424 | $ | — | $ | 102 | $ | 374 | $ | 900 | |||||||||
____________________
(1) | While the Company’s exposures are shown in U.S. dollars, the obligations the Company insures are in various currencies, primarily Euros. One of the residential mortgage-backed securities included in the table above includes residential mortgages in both Italy and Germany, and only the portion of the transaction equal to the portion of the original mortgage pool in Italian mortgages is shown in the table. |
(2) | The exposure shown in the “Non-infrastructure public finance” category is from transactions backed by receivable payments from sub-sovereigns in Italy, Spain and Portugal. Sub-sovereign debt is debt issued by a governmental entity or government backed entity, or supported by such an entity, that is other than direct sovereign debt of the ultimate governing body of the country. |
When the Company directly insures an obligation, it assigns the obligation to a geographic location or locations based on its view of the geographic location of the risk. The Company may also have direct exposures to the Selected European Countries in business assumed from unaffiliated monoline insurance companies, in which case the Company depends upon geographic information provided by the primary insurer.
The Company has excluded from the exposure tables above its indirect economic exposure to the Selected European Countries through policies it provides on pooled corporate and commercial receivables transactions. The Company calculates indirect exposure to a country by multiplying the par amount of a transaction insured by the Company times the percent of the relevant collateral pool reported as having a nexus to the country. On that basis, the Company has calculated exposure of $418 million of Selected European Countries (plus Greece) in transactions with $11.6 billion of net par outstanding. The indirect exposure to credits with a nexus to Greece is $12 million across several highly rated pooled corporate obligations with net par outstanding of $864 million.
152
Exposure to Puerto Rico
The Company insures general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $4.9 billion net par as of December 31, 2014. The Company rates $4.7 billion net par of that amount BIG; included in that amount are the obligations of Puerto Rico Highway and Transportation Authority (“PRHTA”) (transportation), Puerto Rico Electric Power Authority (“PREPA”), and PRHTA (highway).
Puerto Rico has experienced significant general fund budget deficits in recent years. These deficits have been covered primarily with the net proceeds of bond issuances, interim financings provided by Government Development Bank for Puerto Rico (“GDB”) and, in some cases, one-time revenue measures or expense adjustment measures. In addition to high debt levels, Puerto Rico faces a challenging economic environment.
In June 2014, the Puerto Rico legislature passed the Puerto Rico Public Corporation Debt Enforcement and Recovery Act (the "Recovery Act") in order to provide a legislative framework for certain public corporations experiencing severe financial stress to restructure their debt, including PRHTA and PREPA. Subsequently, the Commonwealth stated PREPA might need to seek relief under the Recovery Act due to liquidity constraints, and disclosed PREPA had utilized approximately $42 million on deposit in its reserve account in order to pay debt service due on its bonds on July 1, 2014.
In August 2014, PREPA entered into forbearance agreements with the GDB, its bank lenders, and bondholders and financial guaranty insurers (including AGM and AGC) that hold or guarantee more than 60% of PREPA's outstanding bonds, in order to address its near-term liquidity issues. Creditors, including AGM and AGC, agreed not to exercise available rights and remedies until March 31, 2015, and the bank lenders agreed to extend the maturity of two revolving lines of credit to the same date. PREPA agreed it would continue to make principal and interest payments on its outstanding bonds, and interest payments on its lines of credit. It also agreed it would develop a five year business plan and a recovery program in respect of its operations; a preliminary business plan was released in December 2014. Creditors, including AGM and AGC, have begun discussions among themselves and with PREPA regarding potentially extending the forbearance agreements beyond March 31, 2015, but there can be no assurance that such discussions will result in such an extension.
Investors in bonds issued by PREPA had filed suit in the United States District Court for the District of Puerto Rico asserting the Recovery Act violates the U.S. Constitution. On February 6, 2015, the U.S. District Court for the District of Puerto Rico ruled the Recovery Act is preempted by the U.S. Bankruptcy Code and is therefore void; on February 19, 2015, the Commonwealth appealed the ruling to the U.S. Court of Appeals for the First Circuit. In addition, the Commonwealth's Resident Commissioner has introduced a bill to the U.S. Congress that, if passed, would enable the Commonwealth to authorize one or more of its public corporations to restructure their debts under chapter 9 of the U.S Bankruptcy Code if they were to become insolvent. The passage of the Recovery Act, its subsequent invalidation, and the introduction of legislation that would enable the Commonwealth to authorize chapter 9 protection for its public corporations have resulted in uncertainty among investors about the rights of creditors of the Commonwealth and its related authorities and public corporations.
Following the enactment of the Recovery Act, S&P, Moody’s and Fitch Ratings lowered the credit rating of the Commonwealth’s bonds and the ratings on certain of its public corporations. In February 2015, S&P and Moody’s each again lowered the credit rating of the Commonwealth's bonds and the ratings on certain of its public corporations. The Commonwealth has disclosed its liquidity has been adversely affected by rating agency downgrades and by the limited market access for its debt, and also noted it has relied on short-term financings and interim loans from the GDB and other private lenders, which reliance has constrained its liquidity and increased its near-term refinancing risk.
In December 2014, Puerto Rico's legislature approved a bill designed to stabilize PRHTA and improve the liquidity of the GDB. Signed by the governor on January 15, 2015, the legislation provides for certain tax revenues that would support PRHTA and require the transfer of certain liabilities and revenues from PHRTA to another authority, as well as requiring the transfer of the operations of poorly performing transit facilities to a new authority.
153
Puerto Rico
Gross Par and Gross Debt Service Outstanding
Gross Par Outstanding | Gross Debt Service Outstanding | ||||||||||||||
December 31, 2014 | December 31, 2013 | December 31, 2014 | December 31, 2013 | ||||||||||||
(in millions) | |||||||||||||||
Subject to the Now Voided Recovery Act (1) | $ | 3,058 | $ | 3,279 | $ | 5,326 | $ | 5,748 | |||||||
Not subject to the Now Voided Recovery Act | 2,977 | 3,517 | 4,748 | 5,599 | |||||||||||
Total | $ | 6,035 | $ | 6,796 | $ | 10,074 | $ | 11,347 | |||||||
____________________
(1) | On February 6, 2015, the U.S. District Court for the District of Puerto Rico ruled that the Recovery Act is preempted by the Federal Bankruptcy Code and is therefore void. On February 19, 2015, the Commonwealth appealed the ruling to the U.S. Court of Appeals for the First Circuit. |
The following table shows the Company’s exposure to general obligation bonds of Puerto Rico and various obligations of its related authorities and public corporations.
Puerto Rico
Net Par Outstanding
As of December 31, 2014 | As of December 31, 2013 | |||||||||||
Total | Internal Rating | Total | Internal Rating | |||||||||
(in millions) | ||||||||||||
Exposures subject to the Now Voided Recovery Act: | ||||||||||||
PRHTA (Transportation revenue) | $ | 844 | BB- | $ | 872 | BB- | ||||||
PREPA | 772 | B- | 860 | BB- | ||||||||
Puerto Rico Aqueduct and Sewer Authority | 384 | BB- | 384 | BB- | ||||||||
PRHTA (Highway revenue) | 273 | BB | 302 | BB | ||||||||
Puerto Rico Convention Center District Authority | 174 | BB- | 185 | BB- | ||||||||
Puerto Rico Public Finance Corporation | — | — | 44 | B | ||||||||
Total | 2,447 | 2,647 | ||||||||||
Exposures not subject to the Now Voided Recovery Act: | ||||||||||||
Commonwealth of Puerto Rico - General Obligation Bonds | 1,672 | BB | 1,885 | BB | ||||||||
Puerto Rico Municipal Finance Agency | 399 | BB- | 450 | BB- | ||||||||
Puerto Rico Sales Tax Financing Corporation | 269 | BBB | 268 | A- | ||||||||
Puerto Rico Public Buildings Authority | 100 | BB | 139 | BB | ||||||||
GDB | 33 | BB | 33 | BB | ||||||||
Puerto Rico Infrastructure Finance Authority | 18 | BB- | 18 | BB- | ||||||||
University of Puerto Rico | 1 | BB- | 1 | BB- | ||||||||
Total | 2,492 | 2,794 | ||||||||||
Total net exposure to Puerto Rico | $ | 4,939 | $ | 5,441 | ||||||||
154
The following table shows the scheduled amortization of the general obligation bonds of Puerto Rico and various obligations of its related authorities and public corporations insured and rated BIG by the Company. The Company guarantees payments of interest and principal when those amounts are scheduled to be paid and cannot be required to pay on an accelerated basis. In the event that obligors default on their obligations, the Company would only be required to pay the shortfall between the principal and interest due in any given period and the amount paid by the obligors.
Amortization Schedule of Puerto Rico BIG Net Par Outstanding
and BIG Net Debt Service Outstanding
As of December 31, 2014
Scheduled BIG Net Par Amortization | Scheduled BIG Net Debt Service Amortization | |||||||||||||||||||||||
Subject to the Now Voided Recovery Act | Not Subject to the Now Voided Recovery Act | Total | Subject to the Now Voided Recovery Act | Not Subject to the Now Voided Recovery Act | Total | |||||||||||||||||||
(in millions) | ||||||||||||||||||||||||
2015 | $ | 126 | $ | 205 | $ | 331 | $ | 249 | $ | 319 | $ | 568 | ||||||||||||
2016 | 84 | 183 | 267 | 199 | 287 | 486 | ||||||||||||||||||
2017 | 41 | 166 | 207 | 153 | 262 | 415 | ||||||||||||||||||
2018 | 48 | 109 | 157 | 158 | 195 | 353 | ||||||||||||||||||
2019 | 61 | 126 | 187 | 168 | 207 | 375 | ||||||||||||||||||
2020 | 73 | 182 | 255 | 176 | 258 | 434 | ||||||||||||||||||
2021 | 51 | 58 | 109 | 151 | 124 | 275 | ||||||||||||||||||
2022 | 42 | 67 | 109 | 140 | 129 | 269 | ||||||||||||||||||
2023 | 102 | 40 | 142 | 198 | 99 | 297 | ||||||||||||||||||
2024 | 82 | 78 | 160 | 174 | 136 | 310 | ||||||||||||||||||
2025 - 2029 | 576 | 340 | 916 | 951 | 566 | 1,517 | ||||||||||||||||||
2030 - 2034 | 440 | 387 | 827 | 696 | 541 | 1,237 | ||||||||||||||||||
2035 - 2039 | 397 | 270 | 667 | 526 | 304 | 830 | ||||||||||||||||||
2040 - 2044 | 78 | 12 | 90 | 147 | 13 | 160 | ||||||||||||||||||
2045 - 2047 | 246 | — | 246 | 271 | — | 271 | ||||||||||||||||||
Total | $ | 2,447 | $ | 2,223 | $ | 4,670 | $ | 4,357 | $ | 3,440 | $ | 7,797 | ||||||||||||
4. | Financial Guaranty Insurance Premiums |
The portfolio of outstanding exposures discussed in Note 3, Outstanding Exposure, includes financial guaranty contracts that meet the definition of insurance contracts as well as those that meet the definition of a derivative under GAAP. Amounts presented in this note relate only to financial guaranty insurance contracts, unless otherwise noted. See Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives for amounts that relate to CDS.
Accounting Policies
Accounting for financial guaranty contracts that meet the scope exception under derivative accounting guidance are subject to industry specific guidance for financial guaranty insurance. The accounting for contracts that fall under the financial guaranty insurance definition are consistent whether the contract was written on a direct basis, assumed from another financial guarantor under a reinsurance treaty, ceded to another insurer under a reinsurance treaty, or acquired in a business combination.
Premium receivables comprise the present value of contractual or expected future premium collections discounted using the risk-free rate. Unearned premium reserve represents deferred premium revenue, less claim payments and recoveries received that have not yet been recognized in the statement of operations (“contra-paid”). The following discussion relates to the deferred premium revenue component of the unearned premium reserve, while the contra-paid is discussed in Note 7, Financial Guaranty Insurance Losses.
155
The amount of deferred premium revenue at contract inception is determined as follows:
• | For premiums received upfront on financial guaranty insurance contracts that were originally underwritten by the Company, deferred premium revenue is equal to the amount of cash received. Upfront premiums typically relate to public finance transactions. |
• | For premiums received in installments on financial guaranty insurance contracts that were originally underwritten by the Company, deferred premium revenue is the present value of either (1) contractual premiums due or (2) in cases where the underlying collateral is comprised of homogeneous pools of assets, the expected premiums to be collected over the life of the contract. To be considered a homogeneous pool of assets, prepayments must be contractually prepayable, the amount of prepayments must be probable, and the timing and amount of prepayments must be reasonably estimable. When the Company adjusts prepayment assumptions or expected premium collections, an adjustment is recorded to the deferred premium revenue, with a corresponding adjustment to the premium receivable, and prospective changes are recognized in premium revenues. Premiums receivable are discounted at the risk-free rate at inception and such discount rate is updated only when changes to prepayment assumptions are made that change the expected date of final maturity. Installment premiums typically relate to structured finance transactions, where the insurance premium rate is determined at the inception of the contract but the insured par is subject to prepayment throughout the life of the transaction. |
• | For financial guaranty insurance contracts acquired in a business combination, deferred premium revenue is equal to the fair value of the Company's stand-ready obligation portion of the insurance contract at the date of acquisition based on what a hypothetical similarly rated financial guaranty insurer would have charged for the contract at that date and not the actual cash flows under the insurance contract. The amount of deferred premium revenue may differ significantly from cash collections due primarily to fair value adjustments recorded in connection with a business combination. |
The Company recognizes deferred premium revenue as earned premium over the contractual period or expected period of the contract in proportion to the amount of insurance protection provided. As premium revenue is recognized, a corresponding decrease to the deferred premium revenue is recorded. The amount of insurance protection provided is a function of the insured principal amount outstanding. Accordingly, the proportionate share of premium revenue recognized in a given reporting period is a constant rate calculated based on the relationship between the insured principal amounts outstanding in the reporting period compared with the sum of each of the insured principal amounts outstanding for all periods. When an insured financial obligation is retired before its maturity, the financial guaranty insurance contract is extinguished. Any nonrefundable deferred premium revenue related to that contract is accelerated and recognized as premium revenue. When a premium receivable balance is deemed uncollectible, it is written off to bad debt expense.
For reinsurance assumed contracts, earned premiums reported in the Company's consolidated statements of operations are calculated based upon data received from ceding companies, however, some ceding companies report premium data between 30 and 90 days after the end of the reporting period. The Company estimates earned premiums for the lag period. Differences between such estimates and actual amounts are recorded in the period in which the actual amounts are determined. When installment premiums are related to reinsurance assumed contracts, the Company assesses the credit quality and liquidity of the ceding companies and the impact of any potential regulatory constraints to determine the collectability of such amounts.
156
Financial Guaranty Insurance Premiums
Deferred premium revenue ceded to reinsurers (ceded unearned premium reserve) is recorded as an asset. Direct, assumed and ceded earned premium revenue are presented together as net earned premiums in the statement of operations. Net earned premiums comprise the following:
Net Earned Premiums
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Scheduled net earned premiums | $ | 415 | $ | 470 | $ | 581 | |||||
Acceleration of net earned premiums | 136 | 263 | 249 | ||||||||
Accretion of discount on net premiums receivable | 16 | 17 | 22 | ||||||||
Financial guaranty insurance net earned premiums | 567 | 750 | 852 | ||||||||
Other | 3 | 2 | 1 | ||||||||
Net earned premiums (1) | $ | 570 | $ | 752 | $ | 853 | |||||
___________________
(1) | Excludes $32 million, $60 million and $153 million for the year ended December 31, 2014, 2013 and 2012, respectively, related to consolidated FG VIEs. |
Components of
Unearned Premium Reserve
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||||||||||
Gross | Ceded | Net(1) | Gross | Ceded | Net(1) | ||||||||||||||||||
(in millions) | |||||||||||||||||||||||
Deferred premium revenue: | |||||||||||||||||||||||
Financial guaranty insurance | $ | 4,167 | $ | 387 | $ | 3,780 | $ | 4,647 | $ | 470 | $ | 4,177 | |||||||||||
Other | 0 | — | 0 | 5 | — | 5 | |||||||||||||||||
Deferred premium revenue | $ | 4,167 | $ | 387 | $ | 3,780 | $ | 4,652 | $ | 470 | $ | 4,182 | |||||||||||
Contra-paid(2) | 94 | (6 | ) | 100 | (57 | ) | (18 | ) | (39 | ) | |||||||||||||
Unearned premium reserve | $ | 4,261 | $ | 381 | $ | 3,880 | $ | 4,595 | $ | 452 | $ | 4,143 | |||||||||||
____________________
(1) | Excludes $125 million and $187 million deferred premium revenue and $42 million and $55 million of contra-paid related to FG VIEs as of December 31, 2014 and December 31, 2013, respectively. |
(2) | See Note 7, "Financial Guaranty Insurance Losses– Insurance Contracts' Loss Information" for an explanation of "contra-paid". |
157
Gross Premium Receivable,
Net of Commissions on Assumed Business
Roll Forward
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Beginning of period, December 31 | $ | 876 | $ | 1,005 | $ | 1,003 | |||||
Gross premium written, net of commissions on assumed business | 171 | 145 | 211 | ||||||||
Gross premiums received, net of commissions on assumed business | (230 | ) | (259 | ) | (294 | ) | |||||
Adjustments: | |||||||||||
Changes in the expected term | (66 | ) | (28 | ) | 44 | ||||||
Accretion of discount, net of commissions on assumed business | 10 | 20 | 36 | ||||||||
Foreign exchange translation | (31 | ) | (1 | ) | 13 | ||||||
Consolidation/deconsolidation of FG VIEs | (1 | ) | — | (5 | ) | ||||||
Other adjustments | — | (6 | ) | (3 | ) | ||||||
End of period, December 31 (1) | $ | 729 | $ | 876 | $ | 1,005 | |||||
____________________
(1) | Excludes $19 million, $21 million and $29 million as of December 31, 2014 , 2013 and 2012, respectively, related to consolidated FG VIEs. |
Foreign exchange translation relates to installment premium receivables denominated in currencies other than the U.S. dollar. Approximately 51% and 48% of installment premiums at December 31, 2014 and 2013, respectively, are denominated in currencies other than the U.S. dollar, primarily the Euro and British Pound Sterling.
The timing and cumulative amount of actual collections may differ from expected collections in the tables below due to factors such as foreign exchange rate fluctuations, counterparty collectability issues, accelerations, commutations and changes in expected lives.
Expected Collections of
Gross Premiums Receivable,
Net of Commissions on Assumed Business
(Undiscounted)
As of December 31, 2014 | |||
(in millions) | |||
2015 (January 1 – March 31) | $ | 31 | |
2015 (April 1 – June 30) | 26 | ||
2015 (July 1 – September 30) | 20 | ||
2015 (October 1 – December 31) | 20 | ||
2016 | 74 | ||
2017 | 69 | ||
2018 | 62 | ||
2019 | 58 | ||
2020-2024 | 242 | ||
2025-2029 | 154 | ||
2030-2034 | 106 | ||
After 2034 | 102 | ||
Total(1) | $ | 964 | |
____________________
(1) | Excludes expected cash collections on FG VIEs of $25 million. |
158
Scheduled Net Earned Premiums
As of December 31, 2014 | |||
(in millions) | |||
2015 (January 1 – March 31) | $ | 93 | |
2015 (April 1 – June 30) | 91 | ||
2015 (July 1 – September 30) | 89 | ||
2015 (October 1 – December 31) | 86 | ||
Subtotal 2015 | 359 | ||
2016 | 332 | ||
2017 | 295 | ||
2018 | 269 | ||
2019 | 246 | ||
2020-2024 | 968 | ||
2025-2029 | 615 | ||
2030-2034 | 370 | ||
After 2034 | 326 | ||
Total present value basis(1) | 3,780 | ||
Discount | 208 | ||
Total future value | $ | 3,988 | |
____________________
(1) | Excludes scheduled net earned premiums on consolidated FG VIEs of $125 million. |
Selected Information for Policies Paid in Installments
As of December 31, 2014 | As of December 31, 2013 | ||||||
(dollars in millions) | |||||||
Premiums receivable, net of commission payable | $ | 729 | $ | 876 | |||
Gross deferred premium revenue | 1,370 | 1,576 | |||||
Weighted-average risk-free rate used to discount premiums | 3.5 | % | 3.4 | % | |||
Weighted-average period of premiums receivable (in years) | 9.4 | 9.4 | |||||
5. | Financial Guaranty Insurance Acquisition Costs |
Accounting Policy
Policy acquisition costs that are directly related and essential to successful insurance contract acquisition and ceding commission income on ceded reinsurance contracts are deferred for contracts accounted for as insurance. Amortization of deferred policy acquisition costs includes the accretion of discount on ceding commission income and expense. Acquisition costs associated with derivative contracts are not deferred.
Direct costs related to the acquisition of new and renewal contracts that result directly from and are essential to the contract transaction are capitalized. These costs include expenses such as ceding commissions expense on assumed reinsurance contracts and the cost of underwriting personnel attributable to successful underwriting efforts. Ceding commission expense on assumed reinsurance contracts and ceding commission income on ceded reinsurance contracts that are associated with premiums received in installments are calculated at their contractually defined rates and included in deferred acquisition costs ("DAC"), with a corresponding offset to net premiums receivable or reinsurance balances payable. Management uses its judgment in determining the type and amount of costs to be deferred. The Company conducts an annual study to determine which operating costs qualify for deferral. Costs incurred for soliciting potential customers, market research, training, administration, unsuccessful acquisition efforts, and product development as well as all overhead type costs are charged to expense as incurred. DAC is amortized in proportion to net earned premiums. When an insured obligation is retired early, the remaining related DAC is expensed at that time.
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Expected losses, which include loss adjustment expenses (“LAE”), investment income, and the remaining costs of servicing the insured or reinsured business, are considered in determining the recoverability of DAC.
Rollforward of
Deferred Acquisition Costs
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Beginning of period | $ | 124 | $ | 116 | $ | 132 | |||||
Costs deferred during the period: | |||||||||||
Commissions on assumed and ceded business | 7 | 9 | (13 | ) | |||||||
Premium taxes | 3 | 4 | 4 | ||||||||
Compensation and other acquisition costs | 10 | 8 | 10 | ||||||||
Total | 20 | 21 | 1 | ||||||||
Costs amortized during the period | (23 | ) | (13 | ) | (17 | ) | |||||
End of period | $ | 121 | $ | 124 | $ | 116 | |||||
6. | Expected Loss to be Paid |
The insured portfolio includes policies accounted for under three separate accounting models depending on the characteristics of the contract and the Company's control rights. The Company has paid and expects to pay future losses on policies which fall under each of the three accounting models. The following provides a summarized description of the three accounting models prescribed by GAAP with a reference to the notes that describe the accounting policies and required disclosures throughout this report. The three models are: (1) insurance, (2) derivative and (3) VIE consolidation.
In order to effectively evaluate and manage the economics and liquidity of the entire insured portfolio, management compiles and analyzes loss information for all policies on a consistent basis. The Company monitors and assigns ratings and calculates expected losses in the same manner for all its exposures regardless of form or differing accounting models.
This note provides information regarding expected claim payments to be made under all contracts in the insured portfolio. Net expected loss to be paid in the tables below consists of the present value of future: expected claim and LAE payments, expected recoveries of excess spread in the transaction structures, cessions to reinsurers, and expected recoveries for breaches of representations and warranties ("R&W") and other loss mitigation strategies.
Accounting Policy
Insurance Accounting
For contracts accounted for as financial guaranty insurance, loss and LAE reserve is recorded only to the extent and for the amount that expected losses to be paid exceed unearned premium reserve. As a result, the Company has expected loss to be paid that have not yet been expensed. Such amounts will be recognized in future periods as deferred premium revenue amortizes into income. Expected loss to be paid is important from a liquidity perspective in that it represents the present value of amounts that the Company expects to pay or recover in future periods, regardless of the accounting model. Expected loss to be paid is an important measure used by management to analyze the net economic loss on all contacts. Expected loss to be expensed is important because it presents the Company's projection of incurred losses that will be recognized in future periods (excluding accretion of discount). See Note 7, Financial Guaranty Insurance Losses.
Derivative Accounting, at Fair Value
For contracts that do not meet the financial guaranty scope exception in the derivative accounting guidance (primarily due to the fact that the insured is not required to be exposed to the insured risk throughout the life of the contract), the Company records such credit derivative contracts at fair value on the consolidated balance sheet with changes in fair value recorded in the consolidated statement of operations. The fair value recorded on the balance sheet represents an exit price in a hypothetical market because the Company does not trade its credit derivative contracts. The fair value is determined using significant
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Level 3 inputs in an internally developed model while the expected loss to be paid (which represents the net present value of expected cash outflows) uses methodologies and assumptions consistent with financial guaranty insurance expected losses to be paid. See Note 8, Fair Value Measurement and Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives.
VIE Consolidation, at Fair Value
For financial guaranty insurance contracts issued on the debt of variable interest entities over which the Company is deemed to be the primary beneficiary due to its control rights, as defined in GAAP, the Company consolidates the FG VIE. The Company carries the assets and liabilities of the FG VIEs at fair value under the fair value option election. Management assesses the losses on the insured debt of the consolidated FG VIEs in the same manner as other financial guaranty insurance and credit derivative contracts. See Note 10, Consolidated Variable Interest Entities.
Expected Loss to be Paid
The expected loss to be paid is equal to the present value of expected future cash outflows for claim and LAE payments, net of inflows for expected salvage and subrogation (e.g. excess spread on the underlying collateral, and estimated and contractual recoveries for breaches of representations and warranties), using current risk-free rates. When the Company becomes entitled to the cash flow from the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment or estimated future claim payment, it reduces the expected loss to be paid on the contract. Net expected loss to be paid is defined as expected loss to be paid, net of amounts ceded to reinsurers.
The current risk-free rate is based on the remaining period of the contract used in the premium revenue recognition calculation (i.e., the contractual or expected period, as applicable). The Company updates the discount rate each quarter and records the effect of such changes in economic loss development. Expected cash outflows and inflows are probability weighted cash flows that reflect the likelihood of all possible outcomes. The Company estimates the expected cash outflows and inflows using management's assumptions about the likelihood of all possible outcomes based on all information available to it. Those assumptions consider the relevant facts and circumstances and are consistent with the information tracked and monitored through the Company's risk-management activities.
Economic Loss Development
Economic loss development represents the change in net expected loss to be paid attributable to the effects of changes in assumptions based on observed market trends, changes in discount rates, accretion of discount and the economic effects of loss mitigation efforts.
Expected loss to be paid and economic loss development include the effects of loss mitigation strategies such as negotiated and estimated recoveries for breaches of representations and warranties, and purchases of insured debt obligations. Additionally, in certain cases, issuers of insured obligations elected, or the Company and an issuer mutually agreed as part of a negotiation, to deliver the underlying collateral or insured obligation to the Company.
In circumstances where the Company has purchased its own insured obligations that have expected losses, expected loss to be paid is reduced by the proportionate share of the insured obligation that is held in the investment portfolio. The difference between the purchase price of the obligation and the fair value excluding the value of the Company's insurance, is treated as a paid loss. Assets that are purchased by the Company are recorded in the investment portfolio, at fair value, excluding the value of the Company's insurance. See Note 11, Investments and Cash and Note 8, Fair Value Measurement.
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Loss Estimation Process
The Company’s loss reserve committees estimate expected loss to be paid for all contracts. Surveillance personnel present analyses related to potential losses to the Company’s loss reserve committees for consideration in estimating the expected loss to be paid. Such analyses include the consideration of various scenarios with corresponding probabilities assigned to them. Depending upon the nature of the risk, the Company’s view of the potential size of any loss and the information available to the Company, that analysis may be based upon individually developed cash flow models, internal credit rating assessments and sector-driven loss severity assumptions or judgmental assessments. In the case of its assumed business, the Company may conduct its own analysis as just described or, depending on the Company’s view of the potential size of any loss and the information available to the Company, the Company may use loss estimates provided by ceding insurers. The Company’s loss reserve committees review and refresh the estimate of expected loss to be paid each quarter. The Company’s estimate of ultimate loss on a policy is subject to significant uncertainty over the life of the insured transaction due to the potential for significant variability in credit performance as a result of economic, fiscal and financial market variability over the long duration of most contracts. The determination of expected loss to be paid is an inherently subjective process involving numerous estimates, assumptions and judgments.
The following tables present a roll forward of the present value of net expected loss to be paid for all contracts, whether accounted for as insurance, credit derivatives or FG VIEs, by sector, before and after the benefit for net expected recoveries for contractual breaches of R&W. The Company used weighted average risk-free rates for U.S. dollar denominated obligations, that ranged from 0.0% to 2.95% as of December 31, 2014 and 0.0% to 4.44% as of December 31, 2013.
Net Expected Loss to be Paid
Before Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2014
Net Expected Loss to be Paid (Recovered) as of December 31, 2013(2) | Economic Loss Development | (Paid) Recovered Losses(1) | Net Expected Loss to be Paid (Recovered) as of December 31, 2014(2) | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 25 | $ | (17 | ) | $ | (2 | ) | $ | 6 | |||||
Alt-A first lien | 578 | (13 | ) | (155 | ) | 410 | |||||||||
Option ARM | 164 | (45 | ) | (120 | ) | (1 | ) | ||||||||
Subprime | 422 | 43 | (53 | ) | 412 | ||||||||||
Total first lien | 1,189 | (32 | ) | (330 | ) | 827 | |||||||||
Second lien: | |||||||||||||||
Closed-end second lien | 87 | (3 | ) | 9 | 93 | ||||||||||
HELOCs | (71 | ) | 35 | 17 | (19 | ) | |||||||||
Total second lien | 16 | 32 | 26 | 74 | |||||||||||
Total U.S. RMBS | 1,205 | 0 | (304 | ) | 901 | ||||||||||
TruPS | 51 | (28 | ) | — | 23 | ||||||||||
Other structured finance | 120 | 96 | 2 | 218 | |||||||||||
U.S. public finance | 264 | 183 | (144 | ) | 303 | ||||||||||
Non-U.S. public finance | 57 | (12 | ) | — | 45 | ||||||||||
Other insurance | (3 | ) | (1 | ) | — | (4 | ) | ||||||||
Total | $ | 1,694 | $ | 238 | $ | (446 | ) | $ | 1,486 | ||||||
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Net Expected Loss to be Paid
Before Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2013
Net Expected Loss to be Paid (Recovered) as of December 31, 2012 | Economic Loss Development | (Paid) Recovered Losses(1) | Net Expected Loss to be Paid (Recovered) as of December 31, 2013(2) | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 10 | $ | 16 | $ | (1 | ) | $ | 25 | ||||||
Alt-A first lien | 693 | (40 | ) | (75 | ) | 578 | |||||||||
Option ARM | 460 | 63 | (359 | ) | 164 | ||||||||||
Subprime | 351 | 101 | (30 | ) | 422 | ||||||||||
Total first lien | 1,514 | 140 | (465 | ) | 1,189 | ||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | 99 | (3 | ) | (9 | ) | 87 | |||||||||
HELOCs | 39 | 3 | (113 | ) | (71 | ) | |||||||||
Total second lien | 138 | 0 | (122 | ) | 16 | ||||||||||
Total U.S. RMBS | 1,652 | 140 | (587 | ) | 1,205 | ||||||||||
TruPS | 27 | 7 | 17 | 51 | |||||||||||
Other structured finance | 312 | (41 | ) | (151 | ) | 120 | |||||||||
U.S. public finance | 7 | 239 | 18 | 264 | |||||||||||
Non-U.S. public finance | 52 | 17 | (12 | ) | 57 | ||||||||||
Other insurance | (3 | ) | (10 | ) | 10 | (3 | ) | ||||||||
Total | $ | 2,047 | $ | 352 | $ | (705 | ) | $ | 1,694 | ||||||
____________________
(1) | Net of ceded paid losses, whether or not such amounts have been settled with reinsurers. Ceded paid losses are typically settled 45 days after the end of the reporting period. Such amounts are recorded in reinsurance recoverable on paid losses included in other assets. The Company paid $37 million and $54 million in LAE for the years ended December 31, 2014 and 2013, respectively. |
(2) | Includes expected LAE to be paid of $16 million as of December 31, 2014 and $34 million as of December 31, 2013. |
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Net Expected Recoveries from
Breaches of R&W Rollforward
Year Ended December 31, 2014
Future Net R&W Benefit as of December 31, 2013 | R&W Development and Accretion of Discount During 2014 | R&W (Recovered) During 2014 | Future Net R&W Benefit as of December 31, 2014 (1) | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 4 | $ | (1 | ) | $ | (1 | ) | $ | 2 | |||||
Alt-A first lien | 274 | 131 | (299 | ) | 106 | ||||||||||
Option ARM | 173 | 14 | (172 | ) | 15 | ||||||||||
Subprime | 118 | 50 | (59 | ) | 109 | ||||||||||
Total first lien | 569 | 194 | (531 | ) | 232 | ||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | 98 | (6 | ) | (7 | ) | 85 | |||||||||
HELOC | 45 | 80 | (125 | ) | — | ||||||||||
Total second lien | 143 | 74 | (132 | ) | 85 | ||||||||||
Total | $ | 712 | $ | 268 | $ | (663 | ) | $ | 317 | ||||||
Net Expected Recoveries from
Breaches of R&W Rollforward
Year Ended December 31, 2013
Future Net R&W Benefit as of December 31, 2012 | R&W Development and Accretion of Discount During 2013 | R&W (Recovered) During 2013 | Future Net R&W Benefit as of December 31, 2013 | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 4 | $ | — | $ | — | $ | 4 | |||||||
Alt-A first lien | 378 | 41 | (145 | ) | 274 | ||||||||||
Option ARM | 591 | 161 | (579 | ) | 173 | ||||||||||
Subprime | 109 | 9 | — | 118 | |||||||||||
Total first lien | 1,082 | 211 | (724 | ) | 569 | ||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | 138 | (9 | ) | (31 | ) | 98 | |||||||||
HELOC | 150 | 94 | (199 | ) | 45 | ||||||||||
Total second lien | 288 | 85 | (230 | ) | 143 | ||||||||||
Total | $ | 1,370 | $ | 296 | $ | (954 | ) | $ | 712 | ||||||
____________________
(1) | See the section "Breaches of Representations and Warranties" below for eligible assets held in trust. |
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Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2014
Net Expected Loss to be Paid (Recovered) as of December 31, 2013 | Economic Loss Development | (Paid) Recovered Losses(1) | Net Expected Loss to be Paid (Recovered) as of December 31, 2014 | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 21 | $ | (16 | ) | $ | (1 | ) | $ | 4 | |||||
Alt-A first lien | 304 | (144 | ) | 144 | 304 | ||||||||||
Option ARM | (9 | ) | (59 | ) | 52 | (16 | ) | ||||||||
Subprime | 304 | (7 | ) | 6 | 303 | ||||||||||
Total first lien | 620 | (226 | ) | 201 | 595 | ||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | (11 | ) | 3 | 16 | 8 | ||||||||||
HELOCs | (116 | ) | (45 | ) | 142 | (19 | ) | ||||||||
Total second lien | (127 | ) | (42 | ) | 158 | (11 | ) | ||||||||
Total U.S. RMBS | 493 | (268 | ) | 359 | 584 | ||||||||||
TruPS | 51 | (28 | ) | — | 23 | ||||||||||
Other structured finance | 120 | 96 | 2 | 218 | |||||||||||
U.S. public finance | 264 | 183 | (144 | ) | 303 | ||||||||||
Non-U.S. public finance | 57 | (12 | ) | — | 45 | ||||||||||
Other insurance | (3 | ) | (1 | ) | — | (4 | ) | ||||||||
Total | $ | 982 | $ | (30 | ) | $ | 217 | $ | 1,169 | ||||||
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Net Expected Loss to be Paid
After Net Expected Recoveries for Breaches of R&W
Roll Forward by Sector
Year Ended December 31, 2013
Net Expected Loss to be Paid (Recovered) as of December 31, 2012 | Economic Loss Development | (Paid) Recovered Losses(1) | Net Expected Loss to be Paid (Recovered) as of December 31, 2013 | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 6 | $ | 16 | $ | (1 | ) | $ | 21 | ||||||
Alt-A first lien | 315 | (81 | ) | 70 | 304 | ||||||||||
Option ARM | (131 | ) | (98 | ) | 220 | (9 | ) | ||||||||
Subprime | 242 | 92 | (30 | ) | 304 | ||||||||||
Total first lien | 432 | (71 | ) | 259 | 620 | ||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | (39 | ) | 6 | 22 | (11 | ) | |||||||||
HELOCs | (111 | ) | (91 | ) | 86 | (116 | ) | ||||||||
Total second lien | (150 | ) | (85 | ) | 108 | (127 | ) | ||||||||
Total U.S. RMBS | 282 | (156 | ) | 367 | 493 | ||||||||||
TruPS | 27 | 7 | 17 | 51 | |||||||||||
Other structured finance | 312 | (41 | ) | (151 | ) | 120 | |||||||||
U.S. public finance | 7 | 239 | 18 | 264 | |||||||||||
Non-U.S. public finance | 52 | 17 | (12 | ) | 57 | ||||||||||
Other insurance | (3 | ) | (10 | ) | 10 | (3 | ) | ||||||||
Total | $ | 677 | $ | 56 | $ | 249 | $ | 982 | |||||||
____________________
(1) | Net of ceded paid losses, whether or not such amounts have been settled with reinsurers. Ceded paid losses and recoveries are typically settled 45 days after the end of the reporting period. Such amounts are recorded in reinsurance recoverable on paid losses included in other assets. |
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The following tables present the present value of net expected loss to be paid for all contracts by accounting model, by sector and after the benefit for estimated and contractual recoveries for breaches of R&W.
Net Expected Loss to be Paid (Recovered)
By Accounting Model
As of December 31, 2014
Financial Guaranty Insurance | FG VIEs(1) | Credit Derivatives(2) | Total | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 2 | $ | — | $ | 2 | $ | 4 | |||||||
Alt-A first lien | 288 | 17 | (1 | ) | 304 | ||||||||||
Option ARM | (15 | ) | — | (1 | ) | (16 | ) | ||||||||
Subprime | 163 | 71 | 69 | 303 | |||||||||||
Total first lien | 438 | 88 | 69 | 595 | |||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | (27 | ) | 31 | 4 | 8 | ||||||||||
HELOCs | (26 | ) | 7 | — | (19 | ) | |||||||||
Total second lien | (53 | ) | 38 | 4 | (11 | ) | |||||||||
Total U.S. RMBS | 385 | 126 | 73 | 584 | |||||||||||
TruPS | 1 | — | 22 | 23 | |||||||||||
Other structured finance | 255 | — | (37 | ) | 218 | ||||||||||
U.S. public finance | 303 | — | — | 303 | |||||||||||
Non-U.S. public finance | 45 | — | — | 45 | |||||||||||
Subtotal | $ | 989 | $ | 126 | $ | 58 | 1,173 | ||||||||
Other | (4 | ) | |||||||||||||
Total | $ | 1,169 | |||||||||||||
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Net Expected Loss to be Paid (Recovered)
By Accounting Model
As of December 31, 2013
Financial Guaranty Insurance | FG VIEs(1) | Credit Derivatives(2) | Total | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | 3 | $ | — | $ | 18 | $ | 21 | |||||||
Alt-A first lien | 199 | 31 | 74 | 304 | |||||||||||
Option ARM | (18 | ) | (2 | ) | 11 | (9 | ) | ||||||||
Subprime | 149 | 81 | 74 | 304 | |||||||||||
Total first lien | 333 | 110 | 177 | 620 | |||||||||||
Second lien: | |||||||||||||||
Closed-end second lien | (34 | ) | 25 | (2 | ) | (11 | ) | ||||||||
HELOCs | (41 | ) | (75 | ) | — | (116 | ) | ||||||||
Total second lien | (75 | ) | (50 | ) | (2 | ) | (127 | ) | |||||||
Total U.S. RMBS | 258 | 60 | 175 | 493 | |||||||||||
TruPS | 3 | — | 48 | 51 | |||||||||||
Other structured finance | 161 | — | (41 | ) | 120 | ||||||||||
U.S. public finance | 264 | — | — | 264 | |||||||||||
Non-U.S. public finance | 55 | — | 2 | 57 | |||||||||||
Subtotal | $ | 741 | $ | 60 | $ | 184 | 985 | ||||||||
Other | (3 | ) | |||||||||||||
Total | $ | 982 | |||||||||||||
___________________
(1) Refer to Note 10, Consolidated Variable Interest Entities.
(2) Refer to Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives.
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The following tables present the net economic loss development for all contracts by accounting model, by sector and after the benefit for estimated and contractual recoveries for breaches of R&W.
Net Economic Loss Development (Benefit)
By Accounting Model
Year Ended December 31, 2014
Financial Guaranty Insurance | FG VIEs(1) | Credit Derivatives(2) | Total | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | — | $ | — | $ | (16 | ) | $ | (16 | ) | |||||
Alt-A first lien | (87 | ) | (13 | ) | (44 | ) | (144 | ) | |||||||
Option ARM | (48 | ) | 1 | (12 | ) | (59 | ) | ||||||||
Subprime | (15 | ) | 6 | 2 | (7 | ) | |||||||||
Total first lien | (150 | ) | (6 | ) | (70 | ) | (226 | ) | |||||||
Second lien: | |||||||||||||||
Closed-end second lien | (2 | ) | 8 | (3 | ) | 3 | |||||||||
HELOCs | (128 | ) | 83 | — | (45 | ) | |||||||||
Total second lien | (130 | ) | 91 | (3 | ) | (42 | ) | ||||||||
Total U.S. RMBS | (280 | ) | 85 | (73 | ) | (268 | ) | ||||||||
TruPS | (2 | ) | — | (26 | ) | (28 | ) | ||||||||
Other structured finance | 97 | — | (1 | ) | 96 | ||||||||||
U.S. public finance | 183 | — | — | 183 | |||||||||||
Non-U.S. public finance | (10 | ) | — | (2 | ) | (12 | ) | ||||||||
Subtotal | $ | (12 | ) | $ | 85 | $ | (102 | ) | (29 | ) | |||||
Other | (1 | ) | |||||||||||||
Total | $ | (30 | ) | ||||||||||||
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Net Economic Loss Development (Benefit)
By Accounting Model
Year Ended December 31, 2013
Financial Guaranty Insurance | FG VIEs(1) | Credit Derivatives(2) | Total | ||||||||||||
(in millions) | |||||||||||||||
U.S. RMBS: | |||||||||||||||
First lien: | |||||||||||||||
Prime first lien | $ | (1 | ) | $ | — | $ | 17 | $ | 16 | ||||||
Alt-A first lien | (54 | ) | 5 | (32 | ) | (81 | ) | ||||||||
Option ARM | (62 | ) | (36 | ) | — | (98 | ) | ||||||||
Subprime | 48 | 32 | 12 | 92 | |||||||||||
Total first lien | (69 | ) | 1 | (3 | ) | (71 | ) | ||||||||
Second lien: | |||||||||||||||
Closed-end second lien | 30 | (34 | ) | 10 | 6 | ||||||||||
HELOCs | (91 | ) | (1 | ) | 1 | (91 | ) | ||||||||
Total second lien | (61 | ) | (35 | ) | 11 | (85 | ) | ||||||||
Total U.S. RMBS | (130 | ) | (34 | ) | 8 | (156 | ) | ||||||||
TruPS | — | — | 7 | 7 | |||||||||||
Other structured finance | (36 | ) | — | (5 | ) | (41 | ) | ||||||||
U.S. public finance | 239 | — | — | 239 | |||||||||||
Non-U.S. public finance | 16 | — | 1 | 17 | |||||||||||
Subtotal | $ | 89 | $ | (34 | ) | $ | 11 | 66 | |||||||
Other | (10 | ) | |||||||||||||
Total | $ | 56 | |||||||||||||
___________________
(1) Refer to Note 10, Consolidated Variable Interest Entities.
(2) Refer to Note 9, Financial Guaranty Contracts Accounted for as Credit Derivatives.
Approach to Projecting Losses in U.S. RMBS
The Company projects losses on its insured U.S. RMBS on a transaction-by-transaction basis by projecting the performance of the underlying pool of mortgages over time and then applying the structural features (i.e., payment priorities and tranching) of the RMBS to the projected performance of the collateral over time. The resulting projected claim payments or reimbursements are then discounted using risk-free rates. For transactions where the Company projects it will receive recoveries from providers of R&W, it projects the amount of recoveries and either establishes a recovery for claims already paid or reduces its projected claim payments accordingly.
The further behind a mortgage borrower falls in making payments, the more likely it is that he or she will default. The rate at which borrowers from a particular delinquency category (number of monthly payments behind) eventually default is referred to as the “liquidation rate.” The Company derives its liquidation rate assumptions from observed roll rates, which are the rates at which loans progress from one delinquency category to the next and eventually to default and liquidation. The Company applies liquidation rates to the mortgage loan collateral in each delinquency category and makes certain timing assumptions to project near-term mortgage collateral defaults from loans that are currently delinquent.
Mortgage borrowers that are not more than one payment behind (generally considered performing borrowers) have demonstrated an ability and willingness to pay throughout the recession and mortgage crisis, and as a result are viewed as less likely to default than delinquent borrowers. Performing borrowers that eventually default will also need to progress through delinquency categories before any defaults occur. The Company projects how many of the currently performing loans will default and when they will default, by first converting the projected near term defaults of delinquent borrowers derived from liquidation rates into a vector of conditional default rates ("CDR"), then projecting how the conditional default rates will
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develop over time. Loans that are defaulted pursuant to the conditional default rate after the near-term liquidation of currently delinquent loans represent defaults of currently performing loans and projected re-performing loans. A conditional default rate is the outstanding principal amount of defaulted loans liquidated in the current month divided by the remaining outstanding amount of the whole pool of loans (or “collateral pool balance”). The collateral pool balance decreases over time as a result of scheduled principal payments, partial and whole principal prepayments, and defaults.
In order to derive collateral pool losses from the collateral pool defaults it has projected, the Company applies a loss severity. The loss severity is the amount of loss the transaction experiences on a defaulted loan after the application of net proceeds from the disposal of the underlying property. The Company projects loss severities by sector based on its experience to date. The Company continues to update its evaluation of these exposures as new information becomes available.
The Company has been enforcing claims for breaches of R&W regarding the characteristics of the loans included in the collateral pools. The Company calculates a credit for R&W recoveries to include in its cash flow projections. Where the Company has an agreement with an R&W provider (such as its agreements with Bank of America, Deutsche Bank and UBS, which are described in more detail under "Breaches of Representations and Warranties" below), that credit is based on the agreement or potential agreement. Where the Company does not have an agreement with the R&W provider but the Company believes the R&W provider to be economically viable, the Company estimates what portion of its past and projected future claims it believes will be reimbursed by that provider.
The Company projects the overall future cash flow from a collateral pool by adjusting the payment stream from the principal and interest contractually due on the underlying mortgages for the collateral losses it projects as described above; assumed voluntary prepayments; and servicer advances. The Company then applies an individual model of the structure of the transaction to the projected future cash flow from that transaction’s collateral pool to project the Company’s future claims and claim reimbursements for that individual transaction. Finally, the projected claims and reimbursements are discounted using risk-free rates. The Company runs several sets of assumptions regarding mortgage collateral performance, or scenarios, and probability weights them.
The ultimate performance of the Company’s RMBS transactions remains highly uncertain, may differ from the Company's projections and may be subject to considerable volatility due to the influence of many interrelated factors that are difficult to predict, including the level and timing of loan defaults, changes in housing prices, results from the Company’s loss mitigation activities and other variables. The Company will continue to monitor the performance of its RMBS exposures and will adjust its RMBS loss projection assumptions and scenarios based on actual performance and management’s view of future performance. If actual experience differs from the Company’s assumptions, the losses incurred could be materially different from the estimate.
The Company's RMBS loss projection methodology assumes that the housing and mortgage markets will continue improving. Each period the Company makes a judgment as to whether to change the assumptions it uses to make RMBS loss projections based on its observation during the period of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, and, to the extent it observes changes, it makes a judgment as whether those changes are normal fluctuations or part of a trend.
Year-End 2014 Compared to Year-End 2013 U.S. RMBS Loss Projections
Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology to project first lien RMBS losses as of December 31, 2014 as it used as of December 31, 2013, but it made a number of refinements to reflect its observations, notably:
• | updated the liquidation rates it uses on delinquent loans based on observations and on an assumption that loan modifications (which improve liquidation rates) would over the next year be less frequent than they were over the most recent year |
• | updated the liquidation rate it uses for loans reported as current but that had been reported as modified over the previous twelve months, based on observed data |
• | established a liquidation rate assumption for loans reported as current and not modified in the past twelve months but that had been reported as delinquent in the previous twelve months |
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• | established loss severity assumptions by vintage category as well as product type, rather than just product type as done previously |
• | beginning with the third quarter 2014, each quarter shortened by three months the period it is projecting it will take in the base case to reach the final CDR |
The methodology and revised assumptions the Company uses to project first lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. First Lien RMBS Loss Projections: Alt A First Lien, Option ARM, Subprime and Prime". The Company estimated the impact of all of the refinements to its first lien RMBS assumptions described above to be a decrease of expected losses of approximately $42 million (before adjustments for settlements or loss mitigation purchases).
Based on its observations of the performance of its insured transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology to project second lien RMBS losses as of December 31, 2014 as it used as of December 31, 2013, but it made a number of refinements to reflect its observations, notably with respect to most HELOC projections to:
• | reflect increased recoveries on newly defaulted loans as well as previously defaulted loans |
• | project incremental defaults associated with increased monthly payments that occur when interest-only periods end |
• | increase the assumed final conditional prepayment rate ("CPR") from 10% to 15% |
The net impact of the refinements in the first two bullet points, which were implemented in the third quarter 2014, was an increase of $36 million in expected losses in the Company's base case as of September 30, 2014. The net impact of the refinements in the third bullet point was an increase in $13 million in expected losses in the Company's base case as of December 31, 2014.
The methodology and assumptions the Company uses to project second lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien".
Year-End 2013 Compared to Year-End 2012 U.S. RMBS Loss Projections
Based on the Company's observation during the year of the performance of its insured RMBS transactions (including early stage delinquencies, late stage delinquencies and loss severity) as well as the residential property market and economy in general, the Company chose to use the same general methodology (with the refinements described below) to project RMBS losses as of December 31, 2013 as it used as of December 31, 2012. The Company's use of the same general approach to project RMBS losses as of December 31, 2013 as it used as of December 31, 2012 was consistent with its view at December 31, 2013 that the housing and mortgage market recovery was occurring at a slower pace than it anticipated at December 31, 2012.
The Company refined its first lien RMBS loss projection methodology as of December 31, 2013 to model explicitly the behavior of borrowers with loans that had been modified. The Company has observed that mortgage loan servicers were modifying more mortgage loans (reducing or forbearing from collecting interest or principal or both due on mortgage loans) to reduce the borrowers’ monthly payments and so improve their payment performance than was the case before the mortgage crisis. Borrowers who are current based on their new, reduced monthly payments are generally reported as current, but are more likely to default than borrowers who are current and whose loans have not been modified. The Company believes modified loans are most likely to default again during the first year after modification. The Company set its liquidation rate assumptions as of December 31, 2012 based on observed roll rates and with modification activity in mind. As of December 31, 2013 the Company made a number of refinements to its first lien RMBS loss projection assumptions to treat loan modifications explicitly. Specifically, in the base case approach, it:
• | established a liquidation rate assumption for loans reported as current but that had been reported as modified in the previous 12 months, |
• | assumed that currently delinquent loans that did not roll to liquidation would behave like modified loans, and so applied the modified loan liquidation rate to them, |
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• | increased from two to three years the period over which it calculates the initial CDR based on assumed liquidations of non-performing loans and modified loans, to account for the longer period modified loans will take to default, |
• | increased the period it assumes the transactions will experience the initial loss severity assumption before it improves and the period during which the transaction will experience low voluntary prepayment rates, |
• | established an assumption for servicers not to advance loan payments on all delinquent loans |
The methodology and revised assumptions the Company uses to project first lien RMBS losses and the scenarios it employs are described in more detail below under " - U.S. First Lien RMBS Loss Projections: Alt A First Lien, Option ARM, Subprime and Prime". The refinement in assumptions described above resulted in a reduction of the initial CDRs but the application of the initial CDRs for a longer period, which generally resulted in a higher amount of loans being liquidated at the initial CDR under the refined assumptions than under the initial CDR under the previous assumptions. The Company estimated the impact of all of the refinements to its assumptions described above to be an increase of expected losses of approximately $8 million (before adjustments for settlements or loss mitigation purchases) by running on the first lien RMBS portfolio as of December 31, 2013 base case assumptions similar to what it used as of December 31, 2012 and comparing those results to those results from the refined assumptions.
During 2013 the Company observed improvements in the performance of its second lien RMBS transactions that, when viewed in the context of their performance prior to 2013, suggested those transactions were beginning to respond to the improvements in the residential property market and economy being widely reported by market observers. Based on such observations, in projecting losses for second lien RMBS the Company chose to decrease by two months in its base scenario and by three months in its optimistic scenario the period it assumed it would take the mortgage market to recover as compared to December 31, 2012. Also during 2013 the Company observed material improvements in the delinquency measures of certain second lien RMBS for which the servicing had been transferred, and made certain adjustments on just those transactions to reflect its view that much of this improvement was due to loan modifications and reinstatements made by the new servicer and that such recently modified and reinstated loans may have a higher likelihood of defaulting again. The methodology and assumptions the Company used to project second lien RMBS losses and the scenarios it employed are described in more detail below under " - U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien".
The Company observed some improvement in delinquency trends in most of its RMBS transactions during 2013, with some of that improvement in second liens driven by servicing transfers it effectuated. Such improvement is naturally transmitted to its projections for each individual RMBS transaction, since the projections are based on the delinquency performance of the loans in that individual transaction.
U.S. First Lien RMBS Loss Projections: Alt-A First Lien, Option ARM, Subprime and Prime
The majority of projected losses in first lien RMBS transactions are expected to come from non-performing mortgage loans (those that have been modified or have been delinquent in the previous 12 months, are two or more payments behind, are in foreclosure or that have been foreclosed and so the RMBS issuer owns the underlying real estate). Changes in the amount of non-performing loans from the amount projected in the previous period are one of the primary drivers of loss development in this portfolio. In order to determine the number of defaults resulting from these delinquent and foreclosed loans, the Company applies a liquidation rate assumption to loans in each of various non-performing categories. The Company arrived at its liquidation rates based on data purchased from a third party provider and assumptions about how delays in the foreclosure process and loan modifications may ultimately affect the rate at which loans are liquidated. Each year the Company reviews the most recent twenty-four months of this data and adjusts its liquidation rates based on its observations. The following table shows liquidation assumptions for various non-performing categories.
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First Lien Liquidation Rates
December 31, 2014 | December 31, 2013 | December 31, 2012 | |||
Current Loans Modified in Previous 12 Months | |||||
Alt A and Prime | 25% | 35% | N/A | ||
Option ARM | 25 | 35 | N/A | ||
Subprime | 25 | 35 | N/A | ||
Current Loans Delinquent in the Previous 12 Months | |||||
Alt A and Prime | 25 | N/A | N/A | ||
Option ARM | 25 | N/A | N/A | ||
Subprime | 25 | N/A | N/A | ||
30 – 59 Days Delinquent | |||||
Alt A and Prime | 35 | 50 | 35% | ||
Option ARM | 40 | 50 | 50 | ||
Subprime | 35 | 45 | 30 | ||
60 – 89 Days Delinquent | |||||
Alt A and Prime | 50 | 60 | 55 | ||
Option ARM | 55 | 65 | 65 | ||
Subprime | 40 | 50 | 45 | ||
90+ Days Delinquent | |||||
Alt A and Prime | 60 | 75 | 65 | ||
Option ARM | 65 | 70 | 75 | ||
Subprime | 55 | 60 | 60 | ||
Bankruptcy | |||||
Alt A and Prime | 45 | 60 | 55 | ||
Option ARM | 50 | 60 | 70 | ||
Subprime | 40 | 55 | 50 | ||
Foreclosure | |||||
Alt A and Prime | 75 | 85 | 85 | ||
Option ARM | 80 | 80 | 85 | ||
Subprime | 70 | 70 | 80 | ||
Real Estate Owned | |||||
All | 100 | 100 | 100 | ||
While the Company uses liquidation rates as described above to project defaults of non-performing loans (including current loans modified or delinquent within the last 12 months), it projects defaults on presently current loans by applying a CDR trend. The start of that CDR trend is based on the defaults the Company projects will emerge from currently nonperforming, recently nonperforming and modified loans. The total amount of expected defaults from the non-performing loans is translated into a constant CDR (i.e., the CDR plateau), which, if applied for each of the next 36 months, would be sufficient to produce approximately the amount of defaults that were calculated to emerge from the various delinquency categories. The CDR thus calculated individually on the delinquent collateral pool for each RMBS is then used as the starting point for the CDR curve used to project defaults of the presently performing loans.
In the base case, after the initial 36-month CDR plateau period, each transaction’s CDR is projected to improve over 12 months to an intermediate CDR (calculated as 20% of its CDR plateau); that intermediate CDR is held constant for 36 months and then trails off in steps to a final CDR of 5% of the CDR plateau. In the base case, the Company assumes the final CDR will be reached eight years and six months after the initial 36-month CDR plateau period, which is six months shorter than assumed as of December 31, 2013 but the same calendar date as it assumed as of June 30, 2014. Under the Company’s methodology, defaults projected to occur in the first 36 months represent defaults that can be attributed to loans that were modified or delinquent in the last 12 months or that are currently delinquent or in foreclosure, while the defaults projected to occur using the projected CDR trend after the first 36 month period represent defaults attributable to borrowers that are currently performing or are projected to reperform.
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Another important driver of loss projections is loss severity, which is the amount of loss the transaction incurs on a loan after the application of net proceeds from the disposal of the underlying property. Loss severities experienced in first lien transactions have reached historic high levels, and the Company is assuming in the base case that these high levels generally will continue for another 18 months. The Company determines its initial loss severity based on actual recent experience. The Company then assumes that loss severities begin returning to levels consistent with underwriting assumptions beginning after the initial 18 month period, declining to 40% in the base case over 2.5 years. Beginning for December 31, 2014, the Company differentiated the loss severity assumptions depending on the vintage of the transaction, as shown in the table below.
The following table shows the range as well as the average, weighted by outstanding net insured par, for key assumptions used in the calculation of expected loss to be paid for individual transactions for direct vintage 2004 - 2008 first lien U.S. RMBS.
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Key Assumptions in Base Case Expected Loss Estimates
First Lien RMBS(1)
As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | ||||||||||||||||||
Range | Weighted Average | Range | Weighted Average | Range | Weighted Average | |||||||||||||||
Alt-A First Lien | ||||||||||||||||||||
Plateau CDR | 2.0 | % | – | 13.4% | 7.3% | 2.8 | % | – | 18.4% | 9.7% | 3.8 | % | – | 23.2% | 13.3% | |||||
Intermediate CDR | 0.4 | % | – | 2.7% | 1.5% | 0.6 | % | – | 3.7% | 1.9% | 0.8 | % | – | 4.6% | 2.7% | |||||
Period until intermediate CDR | 48 months | 48 months | 36 months | |||||||||||||||||
Final CDR | 0.1 | % | – | 0.7% | 0.3% | 0.1 | % | – | 0.9% | 0.5% | 0.2 | % | – | 1.2% | 0.6% | |||||
Initial loss severity: | ||||||||||||||||||||
2005 and prior | 60% | 65% | 65% | |||||||||||||||||
2006 | 70% | 65% | 65% | |||||||||||||||||
2007 | 65% | 65% | 65% | |||||||||||||||||
Initial CPR | 1.7 | % | – | 21.0% | 7.7% | 0.0 | % | – | 34.2% | 9.7% | 0.0 | % | – | 39.4% | 7.4% | |||||
Final CPR(2) | 15% | 15% | 15% | |||||||||||||||||
Option ARM | ||||||||||||||||||||
Plateau CDR | 4.3 | % | – | 14.2% | 10.6% | 4.9 | % | – | 16.8% | 11.9% | 7.0 | % | – | 26.1% | 18.4% | |||||
Intermediate CDR | 0.9 | % | – | 2.8% | 2.1% | 1.0 | % | – | 3.4% | 2.4% | 1.4 | % | – | 5.2% | 3.7% | |||||
Period until intermediate CDR | 48 months | 48 months | 36 months | |||||||||||||||||
Final CDR | 0.2 | % | – | 0.7% | 0.5% | 0.2 | % | – | 0.8% | 0.5% | 0.4 | % | – | 1.3% | 0.8% | |||||
Initial loss severity: | ||||||||||||||||||||
2005 and prior | 60% | 65% | 65% | |||||||||||||||||
2006 | 70% | 65% | 65% | |||||||||||||||||
2007 | 65% | 65% | 65% | |||||||||||||||||
Initial CPR | 1.1 | % | – | 11.8% | 4.9% | 0.4 | % | – | 13.1% | 4.7% | 0.0 | % | – | 10.7% | 4.0% | |||||
Final CPR(2) | 15% | 15% | 15% | |||||||||||||||||
Subprime | ||||||||||||||||||||
Plateau CDR | 4.9 | % | – | 15.0% | 10.6% | 5.6 | % | – | 16.2% | 11.8% | 7.3 | % | – | 26.2% | 17.3% | |||||
Intermediate CDR | 1.0 | % | – | 3.0% | 2.1% | 1.1 | % | – | 3.2% | 2.4% | 1.5 | % | – | 5.2% | 3.5% | |||||
Period until intermediate CDR | 48 months | 48 months | 36 months | |||||||||||||||||
Final CDR | 0.2 | % | – | 0.7% | 0.4% | 0.3 | % | – | 0.8% | 0.4% | 0.4 | % | – | 1.3% | 0.6% | |||||
Initial loss severity: | ||||||||||||||||||||
2005 and prior | 75% | 90% | 90% | |||||||||||||||||
2006 | 90% | 90% | 90% | |||||||||||||||||
2007 | 90% | 90% | 90% | |||||||||||||||||
Initial CPR | 0.0 | % | – | 10.5% | 6.1% | 0.0 | % | – | 15.7% | 4.1% | 0.0 | % | – | 17.6% | 3.6% | |||||
Final CPR(2) | 15% | 15% | 15% | |||||||||||||||||
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(1) Represents variables for most heavily weighted scenario (the “base case”).
(2) | For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. |
The rate at which the principal amount of loans is voluntarily prepaid may impact both the amount of losses projected (since that amount is a function of the conditional default rate, the loss severity and the loan balance over time) as well as the
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amount of excess spread (the amount by which the interest paid by the borrowers on the underlying loan exceeds the amount of interest owed on the insured obligations). The assumption for the voluntary CPR follows a similar pattern to that of the conditional default rate. The current level of voluntary prepayments is assumed to continue for the plateau period before gradually increasing over 12 months to the final CPR, which is assumed to be 15% in the base case. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. These assumptions are the same as those the Company used for December 31, 2013 and December 31, 2012 except that, as of December 31, 2014 and December 31, 2013 the period of initial CDRs were assumed to last 12 months longer than they were assumed to last as of December 31, 2012, so the initial CPR is also held constant 12 months longer as of December 31, 2014 and December 31, 2013 than it was as of December 31, 2012.
In estimating expected losses, the Company modeled and probability weighted sensitivities for first lien transactions by varying its assumptions of how fast a recovery is expected to occur. One of the variables used to model sensitivities was how quickly the conditional default rate returned to its modeled equilibrium, which was defined as 5% of the initial conditional default rate. The Company also stressed CPR and the speed of recovery of loss severity rates. The Company probability weighted a total of five scenarios (including its base case) as of December 31, 2014. The Company used a similar approach to establish its pessimistic and optimistic scenarios as of December 31, 2014 as it used as of December 31, 2013 and December 31, 2012, increasing and decreasing the periods of stress from those used in the base case, except that all of the stress periods were longer as of December 31, 2014 and December 31, 2013 than they were as of December 31, 2012.
In a somewhat more stressful environment than that of the base case, where the conditional default rate plateau was extended six months (to be 42 months long) before the same more gradual conditional default rate recovery and loss severities were assumed to recover over 4.5 rather than 2.5 years (and subprime loss severities were assumed to recover only to 60% and Option ARM and Alt A loss severities to only 45%), expected loss to be paid would increase from current projections by approximately $29 million for Alt-A first liens, $9 million for Option ARM, $73 million for subprime and $2 million for prime transactions.
In an even more stressful scenario where loss severities were assumed to rise and then recover over nine years and the initial ramp-down of the conditional default rate was assumed to occur over 15 months and other assumptions were the same as the other stress scenario, expected loss to be paid would increase from current projections by approximately $79 million for Alt-A first liens, $21 million for Option ARM, $102 million for subprime and $7 million for prime transactions.
In a scenario with a somewhat less stressful environment than the base case, where conditional default rate recovery was somewhat less gradual, expected loss to be paid would increase from current projections by approximately $0.3 million for Alt-A first lien and would decrease by $12 million for Option ARM, $10 million for subprime and $0.1 million for prime transactions.
In an even less stressful scenario where the conditional default rate plateau was six months shorter (30 months, effectively assuming that liquidation rates would improve) and the conditional default rate recovery was more pronounced, (including an initial ramp-down of the conditional default rate over nine months), expected loss to be paid would decrease from current projections by approximately $28 million for Alt-A first lien, $26 million for Option ARM, $52 million for subprime and $1 million for prime transactions.
U.S. Second Lien RMBS Loss Projections: HELOCs and Closed-End Second Lien
The Company believes the primary variable affecting its expected losses in second lien RMBS transactions is the amount and timing of future losses in the collateral pool supporting the transactions. Expected losses are also a function of the structure of the transaction; the voluntary prepayment rate (typically also referred to as CPR of the collateral); the interest rate environment; and assumptions about the draw rate and loss severity.
The following table shows the range as well as the average, weighted by outstanding net insured par, for key assumptions for the calculation of expected loss to be paid for individual transactions for direct vintage 2004 - 2008 second lien U.S. RMBS.
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Key Assumptions in Base Case Expected Loss Estimates
Second Lien RMBS(1)
HELOC key assumptions | As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | |||||||||||||||||
Range | Weighted Average | Range | Weighted Average | Range | Weighted Average | |||||||||||||||
Plateau CDR | 2.8 | % | – | 6.8% | 4.1% | 2.3 | % | – | 7.7% | 4.9% | 3.8 | % | – | 15.9% | 8.8% | |||||
Final CDR trended down to | 0.5 | % | – | 3.2% | 1.2% | 0.4 | % | – | 3.2% | 1.1% | 0.4 | % | – | 3.2% | 1.2% | |||||
Period until final CDR | 34 months | 34 months | 36 months | |||||||||||||||||
Initial CPR | 6.9 | % | – | 21.8% | 11.0% | 2.7 | % | – | 21.5% | 9.9% | 2.9 | % | – | 15.4% | 6.6% | |||||
Final CPR(2) | 15.0 | % | – | 21.8% | 15.5% | 10% | 10% | |||||||||||||
Loss severity | 90 | % | – | 98% | 90.4% | 98% | 98% | |||||||||||||
Closed-end second lien key assumptions | As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | |||||||||||||||||
Range | Weighted Average | Range | Weighted Average | Range | Weighted Average | |||||||||||||||
Plateau CDR | 5.5 | % | – | 12.5% | 7.2% | 7.3 | % | – | 15.1% | 8.5% | 7.3 | % | – | 20.7% | 12.7% | |||||
Final CDR trended down to | 3.5 | % | – | 9.1% | 4.9% | 3.5 | % | – | 9.1% | 5.0% | 3.5 | % | – | 9.1% | 4.9% | |||||
Period until final CDR | 34 months | 34 months | 36 months | |||||||||||||||||
Initial CPR | 2.8 | % | – | 13.9% | 9.9% | 3.1 | % | – | 12.0% | 7.1% | 1.9 | % | – | 12.5% | 4.0% | |||||
Final CPR(2) | 15% | 10% | 10% | |||||||||||||||||
Loss severity | 98% | 98% | 98% | |||||||||||||||||
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(1) | Represents variables for most heavily weighted scenario (the “base case”). |
(2) | For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. |
In second lien transactions the projection of near-term defaults from currently delinquent loans is relatively straightforward because loans in second lien transactions are generally “charged off” (treated as defaulted) by the securitization’s servicer once the loan is 180 days past due. Most second lien transactions report the amount of loans in five monthly delinquency categories (i.e., 30-59 days past due, 60-89 days past due, 90-119 days past due, 120-149 days past due and 150-179 days past due). The Company estimates the amount of loans that will default over the next five months by calculating current representative liquidation rates (the percent of loans in a given delinquency status that are assumed to ultimately default) from selected representative transactions and then applying an average of the preceding twelve months’ liquidation rates to the amount of loans in the delinquency categories. The amount of loans projected to default in the first through fifth months is expressed as a CDR. The first four months’ CDR is calculated by applying the liquidation rates to the current period past due balances (i.e., the 150-179 day balance is liquidated in the first projected month, the 120-149 day balance is liquidated in the second projected month, the 90-119 day balance is liquidated in the third projected month and the 60-89 day balance is liquidated in the fourth projected month). For the fifth month the CDR is calculated using the average 30-59 day past due balances for the prior three months, adjusted as necessary to reflect one-time service events. The fifth month CDR is then used as the basis for the plateau period that follows the embedded five months of losses.
For the base case scenario, the CDR (the “plateau CDR”) was held constant for one month. Once the plateau period has ended, the CDR is assumed to gradually trend down in uniform increments to its final long-term steady state CDR. (The long-term steady state CDR is calculated as the constant CDR that would have yielded the amount of losses originally expected at underwriting.) In the base case scenario, the time over which the CDR trends down to its final CDR is 28 months. Therefore, the total stress period for second lien transactions is 34 months, comprising five months of delinquent data, a one month plateau period and 28 months of decrease to the steady state CDR, the same as of December 31, 2013. This is two months shorter than used for December 31, 2012.
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HELOC loans generally permit the borrower to pay only interest for an initial period (often ten years) and, after that period, require the borrower to make both the monthly interest payment and a monthly principal payment, and so increase the borrower's aggregate monthly payment. Some of the HELOC loans underlying the Company's insured HELOC transactions have reached their principal amortization period. Based on the Company’s observation, including information obtained over the last year on the performance of certain loans reaching their principal amortization period and its views of the efficacy of planned servicer intervention, it introduced this year an assumption in the projections for most of its HELOC transactions that 7.5% of loans reaching their amortization periods will default around the time of the payment increase. These projected defaults are in addition to those generated using the CDR curve as described above.
When a second lien loan defaults, there is generally a very low recovery. The Company had assumed as of December 31, 2013 that it will recover only 2% of the collateral defaulting. However, based on additional information the Company obtained over the last year, it increased this recovery assumption in the projections for most of its HELOC transactions as of December 31, 2014 to 10% of collateral defaulting in the future, and also assumed declining additional post-default receipts on previously defaulted collateral.
The rate at which the principal amount of loans is prepaid may impact both the amount of losses projected as well as the amount of excess spread. In the base case, the current CPR (based on experience of the most recent three quarters) is assumed to continue until the end of the plateau before gradually increasing to the final CPR over the same period the CDR decreases. For transactions where the initial CPR is higher than the final CPR, the initial CPR is held constant and the final CPR is not used. The final CPR is assumed to be 15% for both HELOC and closed-end second lien transactions, which is lower than the historical average but reflects the Company’s continued uncertainty about the projected performance of the borrowers in these transactions. This pattern is consistent with how the Company modeled the CPR at December 31, 2013. To the extent that prepayments differ from projected levels it could materially change the Company’s projected excess spread and losses.
The net impact of the three refinements the Company made to projecting expected losses in certain HELOC transactions described above (increased defaults of loans reaching their amortization period, increased recoveries, decreased the redefault rate on modified loans and the increase in the final CPR to 15%) was an increase of approximately $53 million in expected losses in the Company's base case as of December 31, 2014 compared to what it would have been without the refinements. The Company uses a number of other variables in its second lien loss projections, including the spread between relevant interest rate indices and HELOC draw rates (the amount of new advances provided on existing HELOCs expressed as a percentage of the current pool balance). These variables have been relatively stable over the past several quarters and in the relevant ranges have less impact on the projection results than the variables discussed above. However, in a number of HELOC transactions the servicers have been modifying poorly performing loans from floating to fixed rates, and, as a result, rising interest rates would negatively impact the excess spread available from these modified loans to support the transactions. The Company incorporated these modifications in its assumptions.
In estimating expected losses, the Company modeled and probability weighted three possible CDR curves applicable to the period preceding the return to the long-term steady state CDR using the same approaches and weightings as it did as of December 31, 2013. The Company believes that the level of the elevated CDR and the length of time it will persist is the primary driver behind the likely amount of losses the collateral will suffer. The Company continues to evaluate the assumptions affecting its modeling results.
The Company’s base case assumed a one month CDR plateau and a 28 month ramp-down (for a total stress period of 34 months). The Company also modeled a scenario with a longer period of elevated defaults and another with a shorter period of elevated defaults. Increasing the CDR plateau to four months and increasing the ramp-down by five months to 33-months (for a total stress period of 42 months) would increase the expected loss by approximately $14 million for HELOC transactions and $1 million for closed-end second lien transactions. On the other hand, keeping the CDR plateau at one month but decreasing the length of the CDR ramp-down to 18 months (for a total stress period of 24 months) would decrease the expected loss by approximately $15 million for HELOC transactions and $1 million for closed-end second lien transactions.
Breaches of Representations and Warranties
Generally, when mortgage loans are transferred into a securitization, the loan originator(s) and/or sponsor(s) provide R&W that the loans meet certain characteristics, and a breach of such R&W often requires that the loan be repurchased from the securitization. In many of the transactions the Company insures, it is in a position to enforce these R&W provisions. The Company has pursued breaches of R&W on a loan-by-loan basis or in cases where a provider of R&W refused to honor its repurchase obligations, the Company sometimes chose to initiate litigation. See “Recovery Litigation” below. The Company's success in pursuing these strategies permitted the Company to enter into agreements with R&W providers under which those
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providers made payments to the Company, agreed to make payments to the Company in the future, and / or repurchased loans from the transactions, all in return for releases of related liability by the Company. In some instances, the entity providing the R&W (or an affiliate of that entity) also benefited from credit protection sold by the Company through a CDS, and the Company entered into an agreement terminating the CDS protection it provided (and so avoiding future losses on that transaction), again in return for releases of related liability by the Company and in certain instances other consideration. Such agreements with R&W providers provide the Company with many of the benefits of pursuing the R&W claims on a loan by loan basis or through litigation, but without the related expense and uncertainty. The Company continues to pursue these strategies against R&W providers with which it does not yet have agreements.
Through December 31, 2014 the Company has caused entities providing R&Ws to pay, or agree to pay, or to terminate insurance protection on future projected losses of, approximately $4.2 billion (gross of reinsurance) in respect of their R&W liabilities for transactions in which the Company has provided insurance.
Based on this success, the Company has included in its net expected loss estimates as of December 31, 2014 an estimated net benefit of $317 million (net of reinsurance). Most of this net benefit is projected to be received pursuant to existing agreements with R&W providers, although some is projected to be received in connection with transactions where the company does not yet have such an agreement. Most of the amount projected to be received pursuant to existing agreements with R&W providers benefits from eligible assets placed in trusts to collateralize the R&W provider’s future reimbursement obligation, with the amount of such collateral subject to increase or decrease from time to time as determined by rating agency requirements. Currently the Company has agreements with three counterparties where a future reimbursement obligation is collateralized by eligible assets held in trust:
• | Bank of America. Under the Company's agreement with Bank of America Corporation and certain of its subsidiaries (“Bank of America”), Bank of America agreed to reimburse the Company for 80% of claims on the first lien transactions covered by the agreement that the Company pays in the future, until the aggregate lifetime collateral losses (not insurance losses or claims) on those transactions reach $6.6 billion. As of December 31, 2014 aggregate lifetime collateral losses on those transactions was $4.1 billion, and the Company was projecting in its base case that such collateral losses would eventually reach $5.1 billion. Bank of America's reimbursement obligation is secured by $574 million of collateral held in trust for the Company's benefit. |
• | Deutsche Bank. Under the Company's May 2012 agreement with Deutsche Bank AG and certain of its affiliates (collectively, “Deutsche Bank”), Deutsche Bank agreed to reimburse the Company for certain claims it pays in the future on eight first and second lien transactions, including 80% of claims it pays on those transactions until the aggregate lifetime claims (before reimbursement) reach $319 million. As of December 31, 2014, the Company was projecting in its base case that such aggregate lifetime claims would remain below $319 million. In the event aggregate lifetime claims paid exceed $389 million, Deutsche Bank must reimburse the Company for 85% of such claims paid (in excess of $389 million) until such claims paid reach $600 million. |
When the agreement was first signed, Deutsche Bank was also required to reimburse AGC for future claims it pays on certain RMBS resecuritizations. AGC and Deutsche Bank terminated one of the resecuritization transactions on October 10, 2013, another on September 12, 2014 and two more in the fourth quarter of 2014. In the fourth quarter of 2014, AGC and Deutsche Bank also terminated one other BIG transaction under which AGC had provided credit protection to Deutsche Bank through a CDS. In connection with the 2014 terminations, AGC and Deutsche Bank agreed to terminate Deutsche Bank’s reimbursement obligation on all of the RMBS resecuritizations, and AGC made a termination payment to Deutsche Bank and released some of the collateral that had been held in trust. Deutsche Bank remains liable to reimburse the Company for certain claims it pays on eight first and second lien transactions, as described above, and such reimbursement obligation remains secured by $77 million of collateral held in trust for the Company’s benefit.
• | UBS. On May 6, 2013, the Company entered into an agreement with UBS Real Estate Securities Inc. and affiliates ("UBS") and a third party resolving the Company’s claims and liabilities related to specified RMBS transactions that were issued, underwritten or sponsored by UBS and insured by AGM or AGC under financial guaranty insurance policies. Under the agreement, UBS agreed to reimburse the Company for 85% of future losses on three first lien RMBS transactions, and such reimbursement obligation is secured by $109 million of collateral held in trust for the Company's benefit. |
For the expected recovery from breaches of R&W in transactions not covered by agreements as of December 31, 2014, the Company did not incorporate any gain contingencies from potential litigation in its estimated repurchases. The amount the Company will ultimately recover related to such contractual R&W is uncertain and subject to a number of factors including the
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counterparty's ability to pay, the number and loss amount of loans determined to have breached R&W and, potentially, negotiated settlements or litigation recoveries. As such, the Company's estimate of recoveries is uncertain and actual amounts realized may differ significantly from these estimates. In arriving at the expected recovery from breaches of R&W not already covered by agreements, the Company considered the creditworthiness of the provider of the R&W, the number of breaches found on defaulted loans, the success rate in resolving these breaches across those transactions where material repurchases have been made and the potential amount of time until the recovery is realized. The calculation of expected recovery from breaches of such contractual R&W involved a variety of scenarios which ranged from the Company recovering substantially all of the losses it incurred due to violations of R&W to the Company realizing limited recoveries. These scenarios were probability weighted in order to determine the recovery incorporated into the Company's estimate of expected losses. This approach was used for both loans that had already defaulted and those assumed to default in the future. The Company adjusts the calculation of its expected recovery from breaches of R&W based on changing facts and circumstances with respect to each counterparty and transaction.
The Company uses the same RMBS projection scenarios and weightings to project its future R&W benefit as it uses to project RMBS losses on its portfolio. To the extent the Company increases its loss projections, the R&W benefit (whether pursuant to an R&W agreement or not) generally will also increase, subject to the agreement limits and thresholds described above. Similarly, to the extent the Company decreases its loss projections, the R&W benefit (whether pursuant to an R&W agreement or not) generally will also decrease, subject to the agreement limits and thresholds described above.
The number of risks subject to R&W recovery is 29, with related net debt service of $2.1 billion as of December 31, 2014 compared to 42 with net debt service of $5.0 billion as of December 31, 2013. Included in these amounts is net debt service related to transactions not yet subject to an agreement. A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making Debt Service payments.
The following table provides a breakdown of the development and accretion amount in the roll forward of estimated recoveries associated with claims for breaches of R&W.
Components of R&W Development
Year Ended December 31, | |||||||
2014 | 2013 | ||||||
(in millions) | |||||||
Inclusion or removal of deals with breaches of R&W during period | $ | — | $ | 6 | |||
Change in recovery assumptions as the result of recovery success | 31 | (6 | ) | ||||
Estimated increase (decrease) in defaults that will result in additional (lower) breaches | (37 | ) | (8 | ) | |||
Settlements and anticipated settlements | 263 | 289 | |||||
Accretion of discount on balance | 11 | 15 | |||||
Total | $ | 268 | $ | 296 | |||
Trust Preferred Securities Collateralized Debt Obligations
The Company has insured or reinsured $4.3 billion of net par (72% of which is in CDS form) of collateralized debt obligations (“CDOs”) backed by TruPS and similar debt instruments, or “TruPS CDOs.” Of the $4.3 billion, $1.3 billion is rated BIG. The underlying collateral in the TruPS CDOs consists of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, real estate investment trusts (“REITs”) and other real estate related issuers.
The Company projects losses for TruPS CDOs by projecting the performance of the asset pools across several scenarios (which it weights) and applying the CDO structures to the resulting cash flows. At December 31, 2014, the Company has projected expected losses to be paid for TruPS CDOs of $23 million. During 2014 there was positive economic development of approximately $28 million, which was due primarily to improving collateral performance throughout 2014.
“XXX” Life Insurance Transactions
The Company’s $3.1 billion net par of XXX life insurance transactions as of December 31, 2014 include $598 million rated BIG. The BIG “XXX” life insurance reserve securitizations are based on discrete blocks of individual life insurance
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business. In each such transaction the monies raised by the sale of the bonds insured by the Company were used to capitalize a special purpose vehicle that provides reinsurance to a life insurer or reinsurer. The monies are invested at inception in accounts managed by third-party investment managers.
The BIG “XXX” life insurance transactions consist of two transactions, notes issued by each of Ballantyne Re p.l.c and Orkney Re II p.l.c. These transactions had material amounts of their assets invested in U.S. RMBS. Based on its analysis of the information currently available, including estimates of future investment performance, and projected credit impairments on the invested assets and performance of the blocks of life insurance business at December 31, 2014, the Company’s projected net expected loss to be paid is $161 million. The economic loss development during 2014 was approximately $93 million, which was due primarily to changes in lapse assumptions on the underlying life insurance policies, modest deterioration in life insurance cash flow projections, and a decrease in the risk free rates used to discount the losses.
Manufactured Housing
The Company insures or reinsures a total of $223 million net par of securities backed by manufactured housing loans, of which $160 million is rated BIG. The Company has expected loss to be paid of $25 million as of December 31, 2014. The economic loss development during 2014 was relatively flat.
Student Loan Transactions
The Company has insured or reinsured $2.5 billion net par of student loan securitizations, of which $1.8 billion was issued by private issuers and classified as asset-backed and $0.7 billion was issued by public authorities and classified as public finance. Of these amounts, $196 million and $101 million, respectively, are rated BIG. The Company is projecting approximately $83 million of net expected loss to be paid in these portfolios. In general, the losses are due to: (i) the poor credit performance of private student loan collateral and high loss severities, or (ii) high interest rates on auction rate securities with respect to which the auctions have failed. The economic loss development during 2014 was approximately $18 million, which was due to a decrease during 2014 in the risk free rates used to discount the losses, and some deterioration in collateral performance during the first six months of 2014.
Selected U.S. Public Finance Transactions
The Company insures general obligation bonds of the Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations aggregating $4.9 billion net par. The Company rates $4.7 billion net par of that amount BIG. For additional information regarding the Company's exposure to general obligations of Commonwealth of Puerto Rico and various obligations of its related authorities and public corporations, please refer to "Exposure to Puerto Rico" in Note 3, Outstanding Exposure.
The Company has net par exposure to the City of Detroit, Michigan of $2.0 billion as of December 31, 2014 to the general obligation and water and sewer utility sectors, as described below (which exposures are now investment grade by virtue of improvements and agreements reached through the bankruptcy process and settlement). In December 2014, the City of Detroit emerged from bankruptcy under Chapter 9 of the U.S. Bankruptcy Code. The City’s proposed plan of adjustment and disclosure statement with the Bankruptcy Court was approved in November 2014.
• | The Company has net par exposure to $1.0 billion of sewer revenue bonds and $878 million of water revenue bonds. The sewer and water systems provide services to areas that extend beyond the city limits, and the bonds are secured by a lien on "special revenues." The Company rates the bonds, which are secured by a lien on "special revenues," BBB. The exposure reflects the City's issuance in September 2014 of new series of sewer and water revenue bonds to finance (i) the purchase of outstanding sewer and water revenue bonds offered and accepted under a tender offer commenced by the City and (ii) the refunding of certain other sewer revenue and revenue refunding bonds, and the Company's insurance of a portion of such issuance. In connection with these transactions, approximately $677 million of the Company's then combined $1.8 billion net par exposure to the sewer and water revenue bonds was purchased in the tender offer or refunded, and the Company insured approximately $841 million gross par of the new sewer and water revenue bonds. Under the City's amended plan of adjustment, the impairment of all outstanding sewer and water revenue bonds (even those not purchased pursuant to the tender offer or refunded) that had been proposed was removed, including those provisions which provided for the impairment of interest rates and call protection on such bonds. |
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• | The Company has net par exposure of $107 million to Michigan Finance Authority by virtue of a court ordered exchange with all holders of the City’s general obligation bonds which occurred upon emergence from bankruptcy in December 2014. The Michigan Finance Authority bonds are secured by a pledge of the unlimited tax, full faith, credit and resources of the City and the specific ad valorem taxes approved by the voters solely to pay debt service on the general obligation bonds and additional security in the form of a subordinate statutory lien on, and intercept of, the City’s distributable state aid. |
• | The Company no longer has exposure to the City's Pension Obligation Certificates. Upon the effective date of the City’s plan of adjustment, a commutation agreement between AG Re and Financial Guaranty Insurance Co. ("FGIC") pursuant to which FGIC commuted all the reinsurance AG Re provided to FGIC with respect to the Pension Obligation Certificates became effective. |
On June 28, 2012, the City of Stockton, California filed for bankruptcy protection under Chapter 9 of the U.S. Bankruptcy Code. The Company's net exposure to the City's general fund is $117 million, consisting of pension obligation bonds. The Company also had exposure to lease revenue bonds; as of December 31, 2014, the Company owned all of such bonds and held them in its investment portfolio. On October 3, 2013, the Company reached a settlement with the City regarding the treatment of the bonds insured by the Company in the City's plan of adjustment. Under the terms of the settlement, the Company will continue to receive net revenues from an office building and an option to take title to that building, and will be entitled to certain fixed payments and certain variable payments contingent on the City's revenue growth. On October 30, 2014, the bankruptcy court confirmed the City's plan of adjustment, which includes the terms of such settlement, and the plan became effective on February 25, 2015.
The Company has $336 million of net par exposure to the Louisville Arena Authority. The bond proceeds were used to construct the KFC Yum Center, home to the University of Louisville men's and women's basketball teams. Actual revenues available for Debt Service are well below original projections, and under the Company's internal rating scale, the transaction is BIG.
The Company projects that its total net expected loss across its troubled U.S. public finance credits as of December 31, 2014, which incorporated the likelihood of the outcomes mentioned above, will be $303 million, compared with a net expected loss of $264 million as of December 31, 2013. Economic loss development in 2014 was approximately $183 million, which was primarily attributable to Puerto Rico and Detroit exposures.
Certain Selected European Country Transactions
The Company insures and reinsures credits with sub-sovereign exposure to various Spanish and Portuguese issuers where a Spanish and Portuguese sovereign default may cause the regions also to default. The Company's gross exposure to these Spanish and Portuguese credits is $521 million and $114 million, respectively and exposure net of reinsurance for Spanish and Portuguese credits is $374 million and $102 million, respectively. The Company rates most of these issuers in the BB category due to the financial condition of Spain and Portugal and their dependence on the sovereign. The Company's Hungary exposure is to infrastructure bonds dependent on payments from Hungarian governmental entities and covered mortgage bonds issued by Hungarian banks. The Company's gross exposure to these Hungarian credits is $529 million and its exposure net of reinsurance is $499 million, most of which is rated BIG. The Company estimated net expected losses of $45 million related to these Spanish, Portuguese and Hungarian credits. The positive economic loss development during 2014 was approximately $5 million, which was primarily attributable to the favorable movement in the exchange rates between the US Dollar and both the Euro and Hungarian Forint during the year.
Infrastructure Finance
The Company has insured exposure of approximately $3.0 billion to infrastructure transactions with refinancing risk as to which the Company may need to make claim payments that it did not anticipate paying when the policies were issued. Although the Company may not experience ultimate loss on a particular transaction, the aggregate amount of the claim payments may be substantial and reimbursement may not occur for an extended time, if at all. These transactions generally involve long-term infrastructure projects that were financed by bonds that mature prior to the expiration of the project concession. The Company expected the cash flows from these projects to be sufficient to repay all of the debt over the life of the project concession, but also expected the debt to be refinanced in the market at or prior to its maturity. If the issuer is unable to refinance the debt due to market conditions, the Company may have to pay a claim when the debt matures, and then recover its payment from cash flows produced by the project in the future. The Company generally projects that in most scenarios it will be fully reimbursed for such payments. However, the recovery of the payments is uncertain and may take from 10 to 35 years, depending on the transaction and the performance of the underlying collateral. The Company estimates total claims for
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the two largest transactions with significant refinancing risk, assuming no refinancing, and based on certain performance assumptions could be $1.8 billion on a gross basis; such claims would be payable from 2017 through 2022.
Recovery Litigation
“XXX” Life Insurance Transactions
In December 2008, AGUK filed an action against J.P. Morgan Investment Management Inc. (“JPMIM”), the investment manager in the Orkney Re II transaction, in the Supreme Court of the State of New York alleging that JPMIM engaged in breaches of fiduciary duty, gross negligence and breaches of contract based upon its handling of the investments of Orkney Re II. After AGUK’s claims were dismissed with prejudice in January 2010, AGUK was successful in its subsequent motions and appeals and, as of December 2011, all of AGUK’s claims for breaches of fiduciary duty, gross negligence and contract were reinstated in full. Separately, at the trial court level, discovery is ongoing.
RMBS Transactions
In November 2014, AGM and its affiliate AGC reached a confidential settlement with DLJ Mortgage Capital, Inc., Credit Suisse First Boston Mortgage Securities Corp. and Credit Suisse Securities (USA) LLC to resolve a lawsuit relating to six first lien U.S. RMBS transactions. AGM and AGC sought damages for alleged breaches of representations and warranties in respect of the underlying loans in these transactions, and failure to cure or repurchase defective loans identified by AGM and AGC. On November 25, 2014, the parties filed a joint stipulation discontinuing the lawsuit with prejudice. However, on November 20, 2014, U.S. Bank National Association, as trustee for the transactions, had filed a motion to intervene as a plaintiff in the lawsuit. On November 26, 2014, the trustee submitted a letter stating that the joint stipulation is ineffective and that the lawsuit may be discontinued only by court order, and requesting an opportunity to review and potentially oppose the settlement. The court has yet to rule on the trustee’s motion or the trustee’s letter. AGM believes the trustee’s motion and letter are without merit. In the fourth quarter of 2014, AGM recorded a benefit in connection with the settlement.
Previously, AGM also had sued Deutsche Bank AG affiliates DB Structured Products, Inc. and ACE Securities Corp. on a second lien U.S. RMBS transaction that it had insured. In November 2014, AGM resolved those claims against Deutsche Bank and filed a stipulation with the Supreme Court of the State of New York to dismiss the lawsuit; the court ordered the dismissal of the matter on November 17, 2014.
7. Financial Guaranty Insurance Losses
Accounting Policies
Loss and LAE Reserve
Loss and LAE reserve reported on the balance sheet relates only to direct and assumed reinsurance contracts that are accounted for as insurance, substantially all of which are financial guaranty insurance contracts. The corresponding reserve ceded to reinsurers is reported as reinsurance recoverable on unpaid losses. As discussed in Note 8, Fair Value Measurement, contracts that meet the definition of a derivative, as well as consolidated FG VIE assets and liabilities, are recorded separately at fair value. Any expected losses related to consolidated FG VIEs are eliminated upon consolidation. Any expected losses on credit derivatives are not recorded as loss and LAE reserve on the consolidated balance sheet.
Under financial guaranty insurance accounting, the sum of unearned premium reserve and loss and LAE reserve represents the Company's stand‑ready obligation. Unearned premium reserve is deferred premium revenue, less claim payments and recoveries received that have not yet been recognized in the statement of operations ("contra-paid"). At contract inception, the entire stand-ready obligation is represented by unearned premium reserve. A loss and LAE reserve for an insurance contract is only recorded when the expected loss to be paid net of contra-paid (“total losses”) exceed the deferred premium revenue, on a contract by contract basis.
When a claim payment is made on a contract, it first reduces any recorded loss and LAE reserve. To the extent there is no loss and LAE reserve on a contract, which occurs when total losses are less than deferred premium revenue, or to the extent loss and LAE reserve is not sufficient to cover a claim payment, then such claim payment is recorded as “contra-paid,” which reduces the unearned premium reserve. The contra-paid is recognized in the line item “loss and LAE” in the consolidated statement of operations when and for the amount that total losses exceed the remaining deferred premium revenue on the insurance contract. Loss and LAE in the consolidated statement of operations is presented net of cessions to reinsurers.
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Salvage and Subrogation Recoverable
When the Company becomes entitled to the cash flow from the underlying collateral of an insured credit under salvage and subrogation rights as a result of a claim payment or estimated future claim payment, it reduces the expected loss to be paid on the contract. Such reduction in expected loss to be paid can result in one of the following:
• | a reduction in the corresponding loss and LAE reserve with a benefit to the income statement, |
• | no entry recorded, if “total loss” is not in excess of deferred premium revenue, or |
• | the recording of a salvage asset with a benefit to the income statement if the transaction is in a net recovery position at the reporting date. |
The Company recognizes the expected recovery of claim payments (including recoveries from settlement with R&W providers) made by an acquired subsidiary prior to the date of acquisition, consistent with its policy for recognizing recoveries on all financial guaranty insurance contracts. To the extent that the estimated amount of recoveries increases or decreases, due to changes in facts and circumstances, including the examination of additional loan files and our experience in recovering loans put back to the originator, the Company would recognize a benefit or expense consistent with how changes in the expected recovery of all other claim payments are recorded. The ceded component of salvage and subrogation recoverable is recorded in the line item reinsurance balances payable.
Expected Loss to be Expensed
Expected loss to be expensed represents past or expected future net claim payments that have not yet been expensed. Such amounts will be expensed in future periods as deferred premium revenue amortizes into income on financial guaranty insurance policies. Expected loss to be expensed is the Company's projection of incurred losses that will be recognized in future periods, excluding accretion of discount.
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Insurance Contracts' Loss Information
The following table provides balance sheet information on loss and LAE reserves and salvage and subrogation recoverable, net of reinsurance. The Company used weighted average risk-free rates for U.S. dollar denominated financial guaranty insurance obligations that ranged from 0.0% to 2.95% as of December 31, 2014 and 0.0% to 4.44% as of December 31, 2013. Financial guaranty insurance expected LAE reserve was $12 million as of December 31, 2014 and $27 million as of December 31, 2013.
Loss and LAE Reserve and Salvage and Subrogation Recoverable
Net of Reinsurance
Insurance Contracts
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||||||||||
Loss and LAE Reserve, net | Salvage and Subrogation Recoverable, net | Net Reserve (Recoverable) | Loss and LAE Reserve, net | Salvage and Subrogation Recoverable, net | Net Reserve (Recoverable) | ||||||||||||||||||
(in millions) | |||||||||||||||||||||||
U.S. RMBS: | |||||||||||||||||||||||
First lien: | |||||||||||||||||||||||
Prime first lien | $ | 2 | $ | — | $ | 2 | $ | 3 | $ | — | $ | 3 | |||||||||||
Alt-A first lien | 87 | — | 87 | 108 | — | 108 | |||||||||||||||||
Option ARM | 28 | 40 | (12 | ) | 22 | 47 | (25 | ) | |||||||||||||||
Subprime | 166 | 8 | 158 | 143 | 2 | 141 | |||||||||||||||||
First lien | 283 | 48 | 235 | 276 | 49 | 227 | |||||||||||||||||
Second lien: | |||||||||||||||||||||||
Closed-end second lien | 4 | 39 | (35 | ) | 5 | 45 | (40 | ) | |||||||||||||||
HELOC | 3 | 39 | (36 | ) | 5 | 127 | (122 | ) | |||||||||||||||
Second lien | 7 | 78 | (71 | ) | 10 | 172 | (162 | ) | |||||||||||||||
Total U.S. RMBS | 290 | 126 | 164 | 286 | 221 | 65 | |||||||||||||||||
TruPS | 0 | — | 0 | 2 | — | 2 | |||||||||||||||||
Other structured finance | 236 | 2 | 234 | 145 | 6 | 139 | |||||||||||||||||
U.S. public finance | 243 | 8 | 235 | 189 | 8 | 181 | |||||||||||||||||
Non-U.S. public finance | 30 | — | 30 | 35 | — | 35 | |||||||||||||||||
Financial guaranty | 799 | 136 | 663 | 657 | 235 | 422 | |||||||||||||||||
Other recoverables | — | 13 | (13 | ) | — | 15 | (15 | ) | |||||||||||||||
Subtotal | 799 | 149 | 650 | 657 | 250 | 407 | |||||||||||||||||
Effect of consolidating FG VIEs | (80 | ) | (1 | ) | (79 | ) | (103 | ) | (85 | ) | (18 | ) | |||||||||||
Subtotal | 719 | 148 | 571 | 554 | 165 | 389 | |||||||||||||||||
Other | 2 | 6 | (4 | ) | 2 | 5 | (3 | ) | |||||||||||||||
Total (1) | $ | 721 | $ | 154 | $ | 567 | $ | 556 | $ | 170 | $ | 386 | |||||||||||
____________________
(1) See “Components of Net Reserves (Salvage)” table for loss and LAE reserve and salvage and subrogation recoverable components.
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The following table reconciles the reported gross and ceded reserve and salvage and subrogation amount to the financial guaranty net reserves (salvage) in the financial guaranty BIG transaction loss summary tables.
Components of Net Reserves (Salvage)
Insurance Contracts
As of December 31, 2014 | As of December 31, 2013 | ||||||
(in millions) | |||||||
Loss and LAE reserve | $ | 799 | $ | 592 | |||
Reinsurance recoverable on unpaid losses | (78 | ) | (36 | ) | |||
Loss and LAE reserve, net | 721 | 556 | |||||
Salvage and subrogation recoverable | (151 | ) | (174 | ) | |||
Salvage and subrogation payable(1) | 10 | 19 | |||||
Other recoverables(2) | (13 | ) | (15 | ) | |||
Salvage and subrogation recoverable, net and other recoverable | (154 | ) | (170 | ) | |||
Subtotal | 567 | 386 | |||||
Less: other (non-financial guaranty business) | (4 | ) | (3 | ) | |||
Net reserves (salvage) - financial guaranty | $ | 571 | $ | 389 | |||
____________________
(1) Recorded as a component of reinsurance balances payable.
(2) R&W recoverables recorded in other assets on the consolidated balance sheet.
Balance Sheet Classification of
Net Expected Recoveries for Breaches of R&W
Insurance Contracts
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||||||||||
For all Financial Guaranty Insurance Contracts | Effect of Consolidating FG VIEs | Reported on Balance Sheet(1) | For all Financial Guaranty Insurance Contracts | Effect of Consolidating FG VIEs | Reported on Balance Sheet(1) | ||||||||||||||||||
(in millions) | |||||||||||||||||||||||
Salvage and subrogation recoverable, net | $ | 20 | $ | — | $ | 20 | $ | 122 | $ | (49 | ) | $ | 73 | ||||||||||
Loss and LAE reserve, net | 185 | (8 | ) | 177 | 363 | (24 | ) | 339 | |||||||||||||||
____________________
(1) | The remaining benefit for R&W is either recorded at fair value in FG VIE assets, or not recorded on the balance sheet until the total loss, net of R&W, exceeds unearned premium reserve. |
The table below provides a reconciliation of net expected loss to be paid to net expected loss to be expensed. Expected loss to be paid differs from expected loss to be expensed due to: (1) the contra-paid which represent the claim payments made and recoveries received that have not yet been recognized in the statement of operations, (2) salvage and subrogation recoverable for transactions that are in a net recovery position where the Company has not yet received recoveries on claims previously paid (having the effect of reducing net expected loss to be paid by the amount of the previously paid claim and the expected recovery), but will have no future income effect (because the previously paid claims and the corresponding recovery of those claims will offset in income in future periods), and (3) loss reserves that have already been established (and therefore expensed but not yet paid).
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Reconciliation of Net Expected Loss to be Paid and
Net Expected Loss to be Expensed
Financial Guaranty Insurance Contracts
As of December 31, 2014 | |||
(in millions) | |||
Net expected loss to be paid | $ | 1,115 | |
Less: net expected loss to be paid for FG VIEs | 126 | ||
Total | 989 | ||
Contra-paid, net | (100 | ) | |
Salvage and subrogation recoverable, net of reinsurance | 135 | ||
Loss and LAE reserve, net of reinsurance | (719 | ) | |
Other recoveries (1) | 13 | ||
Net expected loss to be expensed (present value)(2) | $ | 318 | |
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(1) | R&W recoverables recorded in other assets on the consolidated balance sheet. |
(2) | Excludes $89 million as of December 31, 2014 related to consolidated FG VIEs. |
The following table provides a schedule of the expected timing of net expected losses to be expensed. The amount and timing of actual loss and LAE may differ from the estimates shown below due to factors such as refundings, accelerations, commutations, changes in expected lives and updates to loss estimates. This table excludes amounts related to FG VIEs, which are eliminated in consolidation.
Net Expected Loss to be Expensed
Financial Guaranty Insurance Contracts
As of December 31, 2014 | |||
(in millions) | |||
2015 (January 1 – March 31) | $ | 8 | |
2015 (April 1 – June 30) | 8 | ||
2015 (July 1 – September 30) | 8 | ||
2015 (October 1 – December 31) | 9 | ||
Subtotal 2015 | 33 | ||
2016 | 34 | ||
2017 | 27 | ||
2018 | 24 | ||
2019 | 22 | ||
2020-2024 | 79 | ||
2025-2029 | 46 | ||
2030-2034 | 32 | ||
After 2034 | 21 | ||
Net expected loss to be expensed | 318 | ||
Discount | 413 | ||
Total future value | $ | 731 | |
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The following table presents the loss and LAE recorded in the consolidated statements of operations by sector for insurance contracts. Amounts presented are net of reinsurance.
Loss and LAE
Reported on the
Consolidated Statements of Operations
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Structured Finance: | |||||||||||
U.S. RMBS: | |||||||||||
First lien: | |||||||||||
Prime first lien | $ | (1 | ) | $ | 1 | $ | 2 | ||||
Alt-A first lien | (66 | ) | (2 | ) | 51 | ||||||
Option ARM | (37 | ) | (48 | ) | 137 | ||||||
Subprime | 8 | 80 | 38 | ||||||||
First lien | (96 | ) | 31 | 228 | |||||||
Second lien: | |||||||||||
Closed-end second lien | (2 | ) | 18 | 31 | |||||||
HELOC | (31 | ) | (53 | ) | 49 | ||||||
Second lien | (33 | ) | (35 | ) | 80 | ||||||
Total U.S. RMBS | (129 | ) | (4 | ) | 308 | ||||||
TruPS | (1 | ) | (1 | ) | (10 | ) | |||||
Other structured finance | 96 | (34 | ) | 3 | |||||||
Structured finance | (34 | ) | (39 | ) | 301 | ||||||
Public Finance: | |||||||||||
U.S. public finance | 192 | 198 | 51 | ||||||||
Non-U.S. public finance | (1 | ) | 16 | 234 | |||||||
Public finance | 191 | 214 | 285 | ||||||||
Subtotal | 157 | 175 | 586 | ||||||||
Other | (1 | ) | — | (17 | ) | ||||||
Loss and LAE on insurance contracts before FG VIE consolidation | 156 | 175 | 569 | ||||||||
Effect of consolidating FG VIEs | (30 | ) | (21 | ) | (65 | ) | |||||
Loss and LAE | $ | 126 | $ | 154 | $ | 504 | |||||
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The following table provides information on financial guaranty insurance contracts categorized as BIG.
Financial Guaranty Insurance
BIG Transaction Loss Summary
As of December 31, 2014
BIG Categories | |||||||||||||||||||||||||||||||||||
BIG 1 | BIG 2 | BIG 3 | Total BIG, Net | Effect of Consolidating FG VIEs | Total | ||||||||||||||||||||||||||||||
Gross | Ceded | Gross | Ceded | Gross | Ceded | ||||||||||||||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||||||||||||
Number of risks(1) | 164 | (59 | ) | 75 | (15 | ) | 119 | (38 | ) | 358 | — | 358 | |||||||||||||||||||||||
Remaining weighted-average contract period (in years) | 9.9 | 7.4 | 10.1 | 8.9 | 9.6 | 6.9 | 10.3 | — | 10.3 | ||||||||||||||||||||||||||
Outstanding exposure: | |||||||||||||||||||||||||||||||||||
Principal | $ | 12,358 | $ | (2,163 | ) | $ | 2,421 | $ | (286 | ) | $ | 3,067 | $ | (175 | ) | $ | 15,222 | $ | — | $ | 15,222 | ||||||||||||||
Interest | 6,350 | (838 | ) | 1,274 | (121 | ) | 1,034 | (48 | ) | 7,651 | — | 7,651 | |||||||||||||||||||||||
Total(2) | $ | 18,708 | $ | (3,001 | ) | $ | 3,695 | $ | (407 | ) | $ | 4,101 | $ | (223 | ) | $ | 22,873 | $ | — | $ | 22,873 | ||||||||||||||
Expected cash outflows (inflows) | $ | 1,762 | $ | (626 | ) | $ | 763 | $ | (77 | ) | $ | 1,716 | $ | (75 | ) | $ | 3,463 | $ | (345 | ) | $ | 3,118 | |||||||||||||
Potential recoveries | |||||||||||||||||||||||||||||||||||
Undiscounted R&W | (39 | ) | 0 | (48 | ) | 2 | (171 | ) | 9 | (247 | ) | 8 | (239 | ) | |||||||||||||||||||||
Other(3) | (1,687 | ) | 608 | (206 | ) | 5 | (404 | ) | 30 | (1,654 | ) | 177 | (1,477 | ) | |||||||||||||||||||||
Total potential recoveries | (1,726 | ) | 608 | (254 | ) | 7 | (575 | ) | 39 | (1,901 | ) | 185 | (1,716 | ) | |||||||||||||||||||||
Subtotal | 36 | (18 | ) | 509 | (70 | ) | 1,141 | (36 | ) | 1,562 | (160 | ) | 1,402 | ||||||||||||||||||||||
Discount | 3 | 0 | (117 | ) | 11 | (353 | ) | 9 | (447 | ) | 34 | (413 | ) | ||||||||||||||||||||||
Present value of expected cash flows | $ | 39 | $ | (18 | ) | $ | 392 | $ | (59 | ) | $ | 788 | $ | (27 | ) | $ | 1,115 | $ | (126 | ) | $ | 989 | |||||||||||||
Deferred premium revenue | $ | 378 | $ | (70 | ) | $ | 119 | $ | (6 | ) | $ | 312 | $ | (33 | ) | $ | 700 | $ | (116 | ) | $ | 584 | |||||||||||||
Reserves (salvage)(4) | $ | (42 | ) | $ | (5 | ) | $ | 278 | $ | (53 | ) | $ | 482 | $ | (10 | ) | $ | 650 | $ | (79 | ) | $ | 571 | ||||||||||||
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Financial Guaranty Insurance
BIG Transaction Loss Summary
As of December 31, 2013
BIG Categories | |||||||||||||||||||||||||||||||||||
BIG 1 | BIG 2 | BIG 3 | Total BIG, Net | Effect of Consolidating FG VIEs | Total | ||||||||||||||||||||||||||||||
Gross | Ceded | Gross | Ceded | Gross | Ceded | ||||||||||||||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||||||||||||
Number of risks(1) | 185 | (72 | ) | 80 | (24 | ) | 119 | (34 | ) | 384 | — | 384 | |||||||||||||||||||||||
Remaining weighted-average contract period (in years) | 10.5 | 8.1 | 8.3 | 5.9 | 9.8 | 7.2 | 10.5 | — | 10.5 | ||||||||||||||||||||||||||
Outstanding exposure: | |||||||||||||||||||||||||||||||||||
Principal | $ | 15,132 | $ | (2,741 | ) | $ | 2,483 | $ | (160 | ) | $ | 3,189 | $ | (158 | ) | $ | 17,745 | $ | — | $ | 17,745 | ||||||||||||||
Interest | 8,114 | (1,144 | ) | 1,181 | (53 | ) | 1,244 | (52 | ) | 9,290 | — | 9,290 | |||||||||||||||||||||||
Total(2) | $ | 23,246 | $ | (3,885 | ) | $ | 3,664 | $ | (213 | ) | $ | 4,433 | $ | (210 | ) | $ | 27,035 | $ | — | $ | 27,035 | ||||||||||||||
Expected cash outflows (inflows) | $ | 1,853 | $ | (528 | ) | $ | 1,038 | $ | (40 | ) | $ | 1,681 | $ | (62 | ) | $ | 3,942 | $ | (690 | ) | $ | 3,252 | |||||||||||||
Potential recoveries | |||||||||||||||||||||||||||||||||||
Undiscounted R&W | (105 | ) | 1 | (201 | ) | 8 | (356 | ) | 13 | (640 | ) | 72 | (568 | ) | |||||||||||||||||||||
Other(3) | (1,774 | ) | 513 | (470 | ) | 19 | (351 | ) | 19 | (2,044 | ) | 507 | (1,537 | ) | |||||||||||||||||||||
Total potential recoveries | (1,879 | ) | 514 | (671 | ) | 27 | (707 | ) | 32 | (2,684 | ) | 579 | (2,105 | ) | |||||||||||||||||||||
Subtotal | (26 | ) | (14 | ) | 367 | (13 | ) | 974 | (30 | ) | 1,258 | (111 | ) | 1,147 | |||||||||||||||||||||
Discount | 13 | — | (126 | ) | 3 | (352 | ) | 5 | (457 | ) | 51 | (406 | ) | ||||||||||||||||||||||
Present value of expected cash flows | $ | (13 | ) | $ | (14 | ) | $ | 241 | $ | (10 | ) | $ | 622 | $ | (25 | ) | $ | 801 | $ | (60 | ) | $ | 741 | ||||||||||||
Deferred premium revenue | $ | 517 | $ | (90 | ) | $ | 163 | $ | (7 | ) | $ | 303 | $ | (27 | ) | $ | 859 | $ | (178 | ) | $ | 681 | |||||||||||||
Reserves (salvage)(4) | $ | (114 | ) | $ | 1 | $ | 117 | $ | (4 | ) | $ | 420 | $ | (13 | ) | $ | 407 | $ | (18 | ) | $ | 389 | |||||||||||||
____________________
(1) | A risk represents the aggregate of the financial guaranty policies that share the same revenue source for purposes of making Debt Service payments. The ceded number of risks represents the number of risks for which the Company ceded a portion of its exposure. |
(2) | Includes BIG amounts related to FG VIEs. |
(3) | Includes excess spread and draws on HELOCs. |
(4) | See table “Components of net reserves (salvage).” |
Ratings Impact on Financial Guaranty Business
A downgrade of one of the Company’s insurance subsidiaries may result in increased claims under financial guaranties issued by the Company, if the insured obligors were unable to pay.
For example, AGM has issued financial guaranty insurance policies in respect of the obligations of municipal obligors under interest rate swaps. Under the swaps, AGM insures periodic payments owed by the municipal obligors to the bank counterparties. Under certain of the swaps, AGM also insures termination payments that may be owed by the municipal obligors to the bank counterparties. If (i) AGM has been downgraded below the rating trigger set forth in a swap under which it has insured the termination payment, which rating trigger varies on a transaction by transaction basis; (ii) the municipal obligor has the right to cure by, but has failed in, posting collateral, replacing AGM or otherwise curing the downgrade of AGM; (iii) the transaction documents include as a condition that an event of default or termination event with respect to the municipal obligor has occurred, such as the rating of the municipal obligor being downgraded past a specified level, and such condition has been met; (iv) the bank counterparty has elected to terminate the swap; (v) a termination payment is payable by the municipal obligor; and (vi) the municipal obligor has failed to make the termination payment payable by it, then AGM would be required to pay the termination payment due by the municipal obligor, in an amount not to exceed the policy limit set forth in the financial guaranty insurance policy. At AGM's current financial strength ratings, if the conditions giving rise to the
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obligation of AGM to make a termination payment under the swap termination policies were all satisfied, then AGM could pay claims in an amount not exceeding approximately $146 million in respect of such termination payments. Taking into consideration whether the rating of the municipal obligor is below any applicable specified trigger, if the financial strength ratings of AGM were further downgraded below "A" by S&P or below "A2" by Moody's, and the conditions giving rise to the obligation of AGM to make a payment under the swap policies were all satisfied, then AGM could pay claims in an additional amount not exceeding approximately $393 million in respect of such termination payments.
As another example, with respect to variable rate demand obligations ("VRDOs") for which a bank has agreed to provide a liquidity facility, a downgrade of AGM or AGC may provide the bank with the right to give notice to bondholders that the bank will terminate the liquidity facility, causing the bondholders to tender their bonds to the bank. Bonds held by the bank accrue interest at a “bank bond rate” that is higher than the rate otherwise borne by the bond (typically the prime rate plus 2.00% — 3.00%, and capped at the lesser of 25% and the maximum legal limit). In the event the bank holds such bonds for longer than a specified period of time, usually 90-180 days, the bank has the right to demand accelerated repayment of bond principal, usually through payment of equal installments over a period of not less than five years. In the event that a municipal obligor is unable to pay interest accruing at the bank bond rate or to pay principal during the shortened amortization period, a claim could be submitted to AGM or AGC under its financial guaranty policy. As of December 31, 2014, AGM and AGC had insured approximately $6.0 billion net par of VRDOs, of which approximately $0.3 billion of net par constituted VRDOs issued by municipal obligors rated BBB- or lower pursuant to the Company’s internal rating. The specific terms relating to the rating levels that trigger the bank’s termination right, and whether it is triggered by a downgrade by one rating agency or a downgrade by all rating agencies then rating the insurer, vary depending on the transaction.
In addition, AGM may be required to pay claims in respect of AGMH’s former financial products business if Dexia SA and its affiliates, from which the Company had purchased AGMH and its subsidiaries, do not comply with their obligations following a downgrade of the financial strength rating of AGM. Most of the guaranteed investment contracts ("GICs") insured by AGM allow the GIC holder to terminate the GIC and withdraw the funds in the event of a downgrade of AGM below A3 or A-, with no right of the GIC issuer to avoid such withdrawal by posting collateral or otherwise enhancing its credit. Each GIC contract stipulates the thresholds below which the GIC issuer must post eligible collateral, along with the types of securities eligible for posting and the collateralization percentage applicable to each security type. These collateralization percentages range from 100% of the GIC balance for cash posted as collateral to, typically, 108% for asset-backed securities. If the entire aggregate accreted GIC balance of approximately $2.3 billion as of December 31, 2014 were terminated, the assets of the GIC issuers (which had an aggregate accreted principal of approximately $3.4 billion and an aggregate market value of approximately $3.1 billion) would be sufficient to fund the withdrawal of the GIC funds.
8. | Fair Value Measurement |
The Company carries a significant portion of its assets and liabilities at fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., exit price). The price represents the price available in the principal market for the asset or liability. If there is no principal market, then the price is based on a hypothetical market that maximizes the value received for an asset or minimizes the amount paid for a liability (i.e., the most advantageous market).
Fair value is based on quoted market prices, where available. If listed prices or quotes are not available, fair value is based on either internally developed models that primarily use, as inputs, market-based or independently sourced market parameters, including but not limited to yield curves, interest rates and debt prices or with the assistance of an independent third-party using a discounted cash flow approach and the third party’s proprietary pricing models. In addition to market information, models also incorporate transaction details, such as maturity of the instrument and contractual features designed to reduce the Company’s credit exposure, such as collateral rights as applicable.
Valuation adjustments may be made to ensure that financial instruments are recorded at fair value. These adjustments include amounts to reflect counterparty credit quality, the Company’s creditworthiness and constraints on liquidity. As markets and products develop and the pricing for certain products becomes more or less transparent, the Company may refine its methodologies and assumptions. During 2014, no changes were made to the Company’s valuation models that had or are expected to have, a material impact on the Company’s consolidated balance sheets or statements of operations and comprehensive income.
The Company’s methods for calculating fair value produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. The use of different methodologies or assumptions to determine fair value of certain financial instruments could result in a different estimate of fair value at the reporting date.
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The fair value hierarchy is determined based on whether the inputs to valuation techniques used to measure fair value are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect Company estimates of market assumptions. The fair value hierarchy prioritizes model inputs into three broad levels as follows, with Level 1 being the highest and Level 3 the lowest. An asset or liability’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation.
Level 1—Quoted prices for identical instruments in active markets. The Company generally defines an active market as a market in which trading occurs at significant volumes. Active markets generally are more liquid and have a lower bid-ask spread than an inactive market.
Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and observable inputs other than quoted prices, such as interest rates or yield curves and other inputs derived from or corroborated by observable market inputs.
Level 3—Model derived valuations in which one or more significant inputs or significant value drivers are unobservable. Financial instruments are considered Level 3 when their values are determined using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable. Level 3 financial instruments also include those for which the determination of fair value requires significant management judgment or estimation.
Transfers between Levels 1, 2 and 3 are recognized at the end of the period when the transfer occurs. The Company reviews the classification between Levels 1, 2 and 3 quarterly to determine whether a transfer is necessary. During the periods presented, there were no transfers between Level 1, 2 and 3.
Measured and Carried at Fair Value
Fixed-Maturity Securities and Short-Term Investments
The fair value of bonds in the investment portfolio is generally based on prices received from third party pricing services or alternative pricing sources with reasonable levels of price transparency. The pricing services prepare estimates of fair value measurements using their pricing models, which include available relevant market information, benchmark curves, benchmarking of like securities, and sector groupings. Additional valuation factors that can be taken into account are nominal spreads and liquidity adjustments. The pricing services evaluate each asset class based on relevant market and credit information, perceived market movements, and sector news. The market inputs used in the pricing evaluation include: benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, reference data and industry and economic events. Benchmark yields have in many cases taken priority over reported trades for securities that trade less frequently or those that are distressed trades, and therefore may not be indicative of the market. The extent of the use of each input is dependent on the asset class and the market conditions. Given the asset class, the priority of the use of inputs may change or some market inputs may not be relevant. Additionally, the valuation of fixed-maturity investments is more subjective when markets are less liquid due to the lack of market based inputs, which may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur.
Short-term investments, that are traded in active markets, are classified within Level 1 in the fair value hierarchy and are based on quoted market prices. Securities such as discount notes are classified within Level 2 because these securities are typically not actively traded due to their approaching maturity and, as such, their cost approximates fair value.
Prices determined based on models where at least one significant model assumption or input is unobservable, are considered to be Level 3 in the fair value hierarchy. As of December 31, 2014, the Company used models to price 37 fixed-maturity securities, which was 7% or $770 million of the Company’s fixed-maturity securities and short-term investments at fair value. Certain Level 3 securities were priced with the assistance of an independent third-party. The pricing is based on a discounted cash flow approach using the third-party’s proprietary pricing models. The models use inputs such as projected prepayment speeds; severity assumptions; recovery lag assumptions; estimated default rates (determined on the basis of an analysis of collateral attributes, historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); home price depreciation/appreciation rates based on macroeconomic forecasts and recent trading activity. The yield used to discount the projected cash flows is determined by reviewing various attributes of the bond including collateral type, weighted average life, sensitivity to losses, vintage, and convexity, in conjunction with market data on comparable securities. Significant changes to any of these inputs could materially change the expected timing of cash flows within these securities which is a significant factor in determining the fair value of the securities.
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Other Invested Assets
As of December 31, 2014, other invested assets include investments carried and measured at fair value on a recurring basis of $95 million and include primarily investments in the global property catastrophe risk market and investment in a high yield fund that invests primarily in senior loans and bonds. Both of these investments were classified as Level 3. As of December 31, 2013, other invested assets included investments carried and measured at fair value on a recurring basis of $121 million and included primarily certain short-term investments and fixed-maturity securities classified as trading carried as Level 2.
Other Assets
Committed Capital Securities
The fair value of committed capital securities ("CCS"), which is recorded in “other assets” on the consolidated balance sheets, represents the difference between the present value of remaining expected put option premium payments under AGC’s CCS (the “AGC CCS”) and AGM’s Committed Preferred Trust Securities (the “AGM CPS”) agreements, and the estimated present value that the Company would hypothetically have to pay currently for a comparable security (see Note 17, Long Term Debt and Credit Facilities). The AGC CCS and AGM CPS are carried at fair value with changes in fair value recorded on the consolidated statement of operations. The estimated current cost of the Company’s CCS is based on several factors, including broker-dealer quotes for the outstanding securities, the U.S. dollar forward swap curve, London Interbank Offered Rate ("LIBOR") curve projections and the term the securities are estimated to remain outstanding.
Supplemental Executive Retirement Plans
The Company classifies the fair value measurement of the assets of the Company's various supplemental executive retirement plans as either Level 1 or Level 2. The fair value of these assets is valued based on the observable published daily values of the underlying mutual fund included in the aforementioned plans (Level 1) or based upon the net asset value of the funds if a published daily value is not available (Level 2). The net asset values are based on observable information.
Financial Guaranty Contracts Accounted for as Credit Derivatives
The Company’s credit derivatives consist primarily of insured CDS contracts, and also include interest rate swaps that fall under derivative accounting standards requiring fair value accounting through the statement of operations. The Company does not enter into CDS with the intent to trade these contracts and the Company may not unilaterally terminate a CDS contract absent an event of default or termination event that entitles the Company to terminate; however, the Company has mutually agreed with various counterparties to terminate certain CDS transactions. Such terminations generally are not completed at fair value but instead for an amount that approximates the present value of future premiums or for an amount negotiated as part of an R&W settlement.
The terms of the Company’s CDS contracts differ from more standardized credit derivative contracts sold by companies outside the financial guaranty industry. The non-standard terms include the absence of collateral support agreements or immediate settlement provisions. In addition, the Company employs relatively high attachment points and does not exit derivatives it sells or purchases for credit protection purposes, except under specific circumstances such as mutual agreements with counterparties. Management considers the non-standard terms of its credit derivative contracts in determining the fair value of these contracts.
Due to the lack of quoted prices and other observable inputs for its instruments or for similar instruments, the Company determines the fair value of its credit derivative contracts primarily through internally developed, proprietary models that use both observable and unobservable market data inputs to derive an estimate of the fair value of the Company's contracts in its principal markets (see "Assumptions and Inputs"). There is no established market where financial guaranty insured credit derivatives are actively traded, therefore, management has determined that the exit market for the Company’s credit derivatives is a hypothetical one based on its entry market. Management has tracked the historical pricing of the Company’s deals to establish historical price points in the hypothetical market that are used in the fair value calculation. These contracts are classified as Level 3 in the fair value hierarchy since there is reliance on at least one unobservable input deemed significant to the valuation model, most importantly the Company’s estimate of the value of the non-standard terms and conditions of its credit derivative contracts and of the Company’s current credit standing.
The Company’s models and the related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely and relevant market information.
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The fair value of the Company’s credit derivative contracts represents the difference between the present value of remaining premiums the Company expects to receive or pay and the estimated present value of premiums that a financial guarantor of comparable credit-worthiness would hypothetically charge or pay at the reporting date for the same protection. The fair value of the Company’s credit derivatives depends on a number of factors, including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of referenced entities, the Company’s own credit risk and remaining contractual cash flows. The expected remaining contractual premium cash flows are the most readily observable inputs since they are based on the CDS contractual terms. Credit spreads capture the effect of recovery rates and performance of underlying assets of these contracts, among other factors. Consistent with previous years, market conditions at December 31, 2014 were such that market prices of the Company’s CDS contracts were not available.
Management considers factors such as current prices charged for similar agreements, when available, performance of underlying assets, life of the instrument, and the nature and extent of activity in the financial guaranty credit derivative marketplace. The assumptions that management uses to determine the fair value may change in the future due to market conditions. Due to the inherent uncertainties of the assumptions used in the valuation models, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements and the differences may be material.
Assumptions and Inputs
The various inputs and assumptions that are key to the establishment of the Company’s fair value for CDS contracts are as follows:
• | Gross spread. |
• | The allocation of gross spread among: |
◦ | the profit the originator, usually an investment bank, realizes for putting the deal together and funding the transaction (“bank profit”); |
◦ | premiums paid to the Company for the Company’s credit protection provided (“net spread”); and |
◦ | the cost of CDS protection purchased by the originator to hedge their counterparty credit risk exposure to the Company (“hedge cost”). |
• | The weighted average life which is based on Debt Service schedules. |
The rates used to discount future expected premium cash flows ranged from 0.26% to 2.70% at December 31, 2014 and 0.21% to 3.88% at December 31, 2013.
The Company obtains gross spreads on its outstanding contracts from market data sources published by third parties (e.g., dealer spread tables for the collateral similar to assets within the Company’s transactions), as well as collateral-specific spreads provided by trustees or obtained from market sources. If observable market credit spreads are not available or reliable for the underlying reference obligations, then market indices are used that most closely resemble the underlying reference obligations, considering asset class, credit quality rating and maturity of the underlying reference obligations. These indices are adjusted to reflect the non-standard terms of the Company’s CDS contracts. Market sources determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. Management validates these quotes by cross-referencing quotes received from one market source against quotes received from another market source to ensure reasonableness. In addition, the Company compares the relative change in price quotes received from one quarter to another, with the relative change experienced by published market indices for a specific asset class. Collateral specific spreads obtained from third-party, independent market sources are un-published spread quotes from market participants or market traders who are not trustees. Management obtains this information as the result of direct communication with these sources as part of the valuation process.
With respect to CDS transactions for which there is an expected claim payment within the next twelve months, the allocation of gross spread reflects a higher allocation to the cost of credit rather than the bank profit component. In the current market, it is assumed that a bank would be willing to accept a lower profit on distressed transactions in order to remove these transactions from its financial statements.
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The following spread hierarchy is utilized in determining which source of gross spread to use, with the rule being to use CDS spreads where available. If not available, CDS spreads are either interpolated or extrapolated based on similar transactions or market indices.
• | Actual collateral specific credit spreads (if up-to-date and reliable market-based spreads are available). |
• | Deals priced or closed during a specific quarter within a specific asset class and specific rating. There were no deals closed during the period presented. |
• | Credit spreads interpolated based upon market indices. |
• | Credit spreads provided by the counterparty of the CDS. |
• | Credit spreads extrapolated based upon transactions of similar asset classes, similar ratings, and similar time to maturity. |
Information by Credit Spread Type (1)
As of December 31, 2014 | As of December 31, 2013 | ||||
Based on actual collateral specific spreads | 9 | % | 6 | % | |
Based on market indices | 82 | % | 88 | % | |
Provided by the CDS counterparty | 9 | % | 6 | % | |
Total | 100 | % | 100 | % | |
____________________
(1) Based on par.
Over time the data inputs can change as new sources become available or existing sources are discontinued or are no longer considered to be the most appropriate. In the fourth quarter of 2014, new market indices were published on Option ARM and Alt-A first lien securitizations. As part of the Company’s normal review process the Company reviewed these indices and based upon the collateral make-up, collateral vintage, and collateral loss experience, determined it to be a better market indication for the Company’s Option ARM and Alt-A first lien securitizations. It is the Company’s objective to move to higher levels on the hierarchy whenever possible, but it is sometimes necessary to move to lower priority inputs because of discontinued data sources or management’s assessment that the higher priority inputs are no longer considered to be representative of market spreads for a given type of collateral. This can happen, for example, if transaction volume changes such that a previously used spread index is no longer viewed as being reflective of current market levels.
The Company interpolates a curve based on the historical relationship between the premium the Company receives when a credit derivative is closed to the daily closing price of the market index related to the specific asset class and rating of the deal. This curve indicates expected credit spreads at each indicative level on the related market index. For transactions with unique terms or characteristics where no price quotes are available, management extrapolates credit spreads based on a similar transaction for which the Company has received a spread quote from one of the first three sources within the Company’s spread hierarchy. This alternative transaction will be within the same asset class, have similar underlying assets, similar credit ratings, and similar time to maturity. The Company then calculates the percentage of relative spread change quarter over quarter for the alternative transaction. This percentage change is then applied to the historical credit spread of the transaction for which no price quote was received in order to calculate the transactions’ current spread. Counterparties determine credit spreads by reviewing new issuance pricing for specific asset classes and receiving price quotes from their trading desks for the specific asset in question. These quotes are validated by cross-referencing quotes received from one market source with those quotes received from another market source to ensure reasonableness.
The premium the Company receives is referred to as the “net spread.” The Company’s pricing model takes into account not only how credit spreads on risks that it assumes affect pricing, but also how the Company’s own credit spread affects the pricing of its deals. The Company’s own credit risk is factored into the determination of net spread based on the impact of changes in the quoted market price for credit protection bought on the Company, as reflected by quoted market prices on CDS referencing AGC or AGM. For credit spreads on the Company’s name the Company obtains the quoted price of CDS contracts traded on AGC and AGM from market data sources published by third parties. The cost to acquire CDS protection referencing AGC or AGM affects the amount of spread on CDS deals that the Company retains and, hence, their fair value. As
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the cost to acquire CDS protection referencing AGC or AGM increases, the amount of premium the Company retains on a deal generally decreases. As the cost to acquire CDS protection referencing AGC or AGM decreases, the amount of premium the Company retains on a deal generally increases. In the Company’s valuation model, the premium the Company captures is not permitted to go below the minimum rate that the Company would currently charge to assume similar risks. This assumption can have the effect of mitigating the amount of unrealized gains that are recognized on certain CDS contracts. Given the current market conditions and the Company’s own credit spreads, approximately 21% and 61% based on number of deals of the Company's CDS contracts are fair valued using this minimum premium as of December 31, 2014 and December 31, 2013, respectively. The percentage of deals that price using the minimum premiums has fluctuated since December 31, 2013 due to changes in AGM's and AGC's credit spreads. In general when AGM's and AGC's credit spreads narrow, the cost to hedge AGM's and AGC's name declines and more transactions price above previously established floor levels. Meanwhile, when AGM's and AGC's credit spreads widen, the cost to hedge AGM's and AGC's name increases causing more transactions to price at previously established floor levels. The Company corroborates the assumptions in its fair value model, including the portion of exposure to AGC and AGM hedged by its counterparties, with independent third parties each reporting period. The current level of AGC’s and AGM’s own credit spread has resulted in the bank or deal originator hedging a significant portion of its exposure to AGC and AGM. This reduces the amount of contractual cash flows AGC and AGM can capture as premium for selling its protection.
The amount of premium a financial guaranty insurance market participant can demand is inversely related to the cost of credit protection on the insurance company as measured by market credit spreads assuming all other assumptions remain constant. This is because the buyers of credit protection typically hedge a portion of their risk to the financial guarantor, due to the fact that the contractual terms of the Company's contracts typically do not require the posting of collateral by the guarantor. The extent of the hedge depends on the types of instruments insured and the current market conditions.
A fair value resulting in a credit derivative asset on protection sold is the result of contractual cash inflows on in-force deals in excess of what a hypothetical financial guarantor could receive if it sold protection on the same risk as of the reporting date. If the Company were able to freely exchange these contracts (i.e., assuming its contracts did not contain proscriptions on transfer and there was a viable exchange market), it would be able to realize a gain representing the difference between the higher contractual premiums to which it is entitled and the current market premiums for a similar contract. The Company determines the fair value of its CDS contracts by applying the difference between the current net spread and the contractual net spread for the remaining duration of each contract to the notional value of its CDS contracts and taking the present value of such amounts discounted at the corresponding LIBOR over the weighted average remaining life of the contract.
Example
Following is an example of how changes in gross spreads, the Company’s own credit spread and the cost to buy protection on the Company affect the amount of premium the Company can demand for its credit protection. The assumptions used in these examples are hypothetical amounts. Scenario 1 represents the market conditions in effect on the transaction date and Scenario 2 represents market conditions at a subsequent reporting date.
Scenario 1 | Scenario 2 | ||||||||||
bps | % of Total | bps | % of Total | ||||||||
Original gross spread/cash bond price (in bps) | 185 | 500 | |||||||||
Bank profit (in bps) | 115 | 62 | % | 50 | 10 | % | |||||
Hedge cost (in bps) | 30 | 16 | % | 440 | 88 | % | |||||
The premium the Company receives per annum (in bps) | 40 | 22 | % | 10 | 2 | % | |||||
In Scenario 1, the gross spread is 185 basis points. The bank or deal originator captures 115 basis points of the original gross spread and hedges 10% of its exposure to AGC, when the CDS spread on AGC was 300 basis points (300 basis points × 10% = 30 basis points). Under this scenario the Company receives premium of 40 basis points, or 22% of the gross spread.
In Scenario 2, the gross spread is 500 basis points. The bank or deal originator captures 50 basis points of the original gross spread and hedges 25% of its exposure to AGC, when the CDS spread on AGC was 1,760 basis points (1,760 basis points × 25% = 440 basis points). Under this scenario the Company would receive premium of 10 basis points, or 2% of the gross spread. Due to the increased cost to hedge AGC’s name, the amount of profit the bank would expect to receive, and the premium the Company would expect to receive decline significantly.
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In this example, the contractual cash flows (the Company premium received per annum above) exceed the amount a market participant would require the Company to pay in today’s market to accept its obligations under the CDS contract, thus resulting in an asset.
Strengths and Weaknesses of Model
The Company’s credit derivative valuation model, like any financial model, has certain strengths and weaknesses.
The primary strengths of the Company’s CDS modeling techniques are:
• | The model takes into account the transaction structure and the key drivers of market value. The transaction structure includes par insured, weighted average life, level of subordination and composition of collateral. |
• | The model maximizes the use of market-driven inputs whenever they are available. The key inputs to the model are market-based spreads for the collateral, and the credit rating of referenced entities. These are viewed by the Company to be the key parameters that affect fair value of the transaction. |
• | The model is a consistent approach to valuing positions. The Company has developed a hierarchy for market-based spread inputs that helps mitigate the degree of subjectivity during periods of high illiquidity. |
The primary weaknesses of the Company’s CDS modeling techniques are:
• | There is no exit market or actual exit transactions. Therefore the Company’s exit market is a hypothetical one based on the Company’s entry market. |
• | There is a very limited market in which to validate the reasonableness of the fair values developed by the Company’s model. |
• | At December 31, 2014 and 2013, the markets for the inputs to the model were highly illiquid, which impacts their reliability. |
• | Due to the non-standard terms under which the Company enters into derivative contracts, the fair value of its credit derivatives may not reflect the same prices observed in an actively traded market of credit derivatives that do not contain terms and conditions similar to those observed in the financial guaranty market. |
These contracts were classified as Level 3 in the fair value hierarchy because there is a reliance on at least one unobservable input deemed significant to the valuation model, most significantly the Company's estimate of the value of non-standard terms and conditions of its credit derivative contracts and amount of protection purchased on AGC or AGM's name.
Fair Value Option on FG VIEs’ Assets and Liabilities
The Company elected the fair value option for all the FG VIEs’ assets and liabilities. See Note 10, Consolidated Variable Interest Entities.
The FG VIEs issued securities collateralized by first lien and second lien RMBS as well as loans and receivables. The lowest level input that is significant to the fair value measurement of these assets and liabilities was a Level 3 input (i.e., unobservable), therefore management classified them as Level 3 in the fair value hierarchy. Prices are generally determined with the assistance of an independent third-party. The pricing is based on a discounted cash flow approach and the third-party’s proprietary pricing models. The models to price the FG VIEs’ liabilities used, where appropriate, inputs such as estimated prepayment speeds; market values of the assets that collateralize the securities; estimated default rates (determined on the basis of an analysis of collateral attributes, historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); yields implied by market prices for similar securities; house price depreciation/appreciation rates based on macroeconomic forecasts and, for those liabilities insured by the Company, the benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest, taking into account the timing of the potential default and the Company’s own credit rating. The third-party also utilizes an internal model to determine an appropriate yield at which to discount the cash flows of the security, by factoring in collateral types, weighted-average lives, and other structural attributes specific to the security being priced. The expected yield is further calibrated by utilizing algorithms designed to aggregate market color, received by the third-party, on comparable bonds.
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The fair value of the Company’s FG VIE assets is generally sensitive to changes related to estimated prepayment speeds; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. Significant changes to some of these inputs could materially change the market value of the FG VIE’s assets and the implied collateral losses within the transaction. In general, the fair value of the FG VIE asset is most sensitive to changes in the projected collateral losses, where an increase in collateral losses typically leads to a decrease in the fair value of FG VIE assets, while a decrease in collateral losses typically leads to an increase in the fair value of FG VIE assets. These factors also directly impact the fair value of the Company’s FG VIE liabilities.
The fair value of the Company’s FG VIE liabilities is also generally sensitive to changes relating to estimated prepayment speeds; market values of the underlying assets; estimated default rates (determined on the basis of an analysis of collateral attributes such as: historical collateral performance, borrower profiles and other features relevant to the evaluation of collateral credit quality); discount rates implied by market prices for similar securities; and house price depreciation/appreciation rates based on macroeconomic forecasts. In addition, the Company’s FG VIE liabilities with recourse are also sensitive to changes in the Company’s implied credit worthiness. Significant changes to any of these inputs could materially change the timing of expected losses within the insured transaction which is a significant factor in determining the implied benefit from the Company’s insurance policy guaranteeing the timely payment of principal and interest for the tranches of debt issued by the FG VIE that is insured by the Company. In general, extending the timing of expected loss payments by the Company into the future typically leads to a decrease in the value of the Company’s insurance and a decrease in the fair value of the Company’s FG VIE liabilities with recourse, while a shortening of the timing of expected loss payments by the Company typically leads to an increase in the value of the Company’s insurance and an increase in the fair value of the Company’s FG VIE liabilities with recourse.
Not Carried at Fair Value
Financial Guaranty Insurance Contracts
The fair value of the Company’s financial guaranty contracts accounted for as insurance was based on management’s estimate of what a similarly rated financial guaranty insurance company would demand to acquire the Company’s in-force book of financial guaranty insurance business. This amount was based on the pricing assumptions management has observed for portfolio transfers that have occurred in the financial guaranty market and included adjustments to the carrying value of unearned premium reserve for stressed losses, ceding commissions and return on capital. The significant inputs were not readily observable. The Company accordingly classified this fair value measurement as Level 3.
Long-Term Debt
The Company’s long-term debt, excluding notes payable, is valued by broker-dealers using third party independent pricing sources and standard market conventions. The market conventions utilize market quotations, market transactions for the Company’s comparable instruments, and to a lesser extent, similar instruments in the broader insurance industry. The fair value measurement was classified as Level 2 in the fair value hierarchy.
The fair value of the notes payable was determined by calculating the present value of the expected cash flows. The Company determines discounted future cash flows using market driven discount rates and a variety of assumptions, including a projection of the LIBOR rate, prepayment and default assumptions, and AGM CDS spreads. The fair value measurement was classified as Level 3 in the fair value hierarchy because there is a reliance on significant unobservable inputs to the valuation model, including the discount rates, prepayment and default assumptions, loss severity and recovery on delinquent loans.
Other Invested Assets
The fair value of the other invested assets was determined by calculating the present value of the expected cash flows. The Company uses a market approach to determine discounted future cash flows using market driven discount rates and a variety of assumptions, including a projection of the LIBOR rate and prepayment and default assumptions. The fair value measurement was classified as Level 3 in the fair value hierarchy because there is a reliance on significant unobservable inputs to the valuation model, including the discount rates, prepayment and default assumptions, loss severity and recovery on delinquent loans.
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Other Assets and Other Liabilities
The Company’s other assets and other liabilities consist predominantly of accrued interest, receivables for securities sold and payables for securities purchased, the carrying values of which approximate fair value.
Financial Instruments Carried at Fair Value
Amounts recorded at fair value in the Company’s financial statements are presented in the tables below.
Fair Value Hierarchy of Financial Instruments Carried at Fair Value
As of December 31, 2014
Fair Value Hierarchy | |||||||||||||||
Fair Value | Level 1 | Level 2 | Level 3 | ||||||||||||
(in millions) | |||||||||||||||
Assets: | |||||||||||||||
Investment portfolio, available-for-sale: | |||||||||||||||
Fixed-maturity securities | |||||||||||||||
Obligations of state and political subdivisions | $ | 5,795 | $ | — | $ | 5,757 | $ | 38 | |||||||
U.S. government and agencies | 665 | — | 665 | — | |||||||||||
Corporate securities | 1,368 | — | 1,289 | 79 | |||||||||||
Mortgage-backed securities: | |||||||||||||||
RMBS | 1,285 | — | 860 | 425 | |||||||||||
CMBS | 659 | — | 659 | — | |||||||||||
Asset-backed securities | 417 | — | 189 | 228 | |||||||||||
Foreign government securities | 302 | — | 302 | — | |||||||||||
Total fixed-maturity securities | 10,491 | — | 9,721 | 770 | |||||||||||
Short-term investments | 767 | 359 | 408 | — | |||||||||||
Other invested assets (1) | 100 | — | 17 | 83 | |||||||||||
Credit derivative assets | 68 | — | — | 68 | |||||||||||
FG VIEs’ assets, at fair value (2) | 1,398 | — | — | 1,398 | |||||||||||
Other assets | 78 | 26 | 17 | 35 | |||||||||||
Total assets carried at fair value | $ | 12,902 | $ | 385 | $ | 10,163 | $ | 2,354 | |||||||
Liabilities: | |||||||||||||||
Credit derivative liabilities | $ | 963 | $ | — | $ | — | $ | 963 | |||||||
FG VIEs’ liabilities with recourse, at fair value | 1,277 | — | — | 1,277 | |||||||||||
FG VIEs’ liabilities without recourse, at fair value | 142 | — | — | 142 | |||||||||||
Total liabilities carried at fair value | $ | 2,382 | $ | — | $ | — | $ | 2,382 | |||||||
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Fair Value Hierarchy of Financial Instruments Carried at Fair Value
As of December 31, 2013
Fair Value Hierarchy | |||||||||||||||
Fair Value | Level 1 | Level 2 | Level 3 | ||||||||||||
(in millions) | |||||||||||||||
Assets: | |||||||||||||||
Investment portfolio, available-for-sale: | |||||||||||||||
Fixed-maturity securities | |||||||||||||||
Obligations of state and political subdivisions | $ | 5,079 | $ | — | $ | 5,043 | $ | 36 | |||||||
U.S. government and agencies | 700 | — | 700 | — | |||||||||||
Corporate securities | 1,340 | — | 1,204 | 136 | |||||||||||
Mortgage-backed securities: | |||||||||||||||
RMBS | 1,122 | — | 832 | 290 | |||||||||||
CMBS | 549 | — | 549 | — | |||||||||||
Asset-backed securities | 608 | — | 340 | 268 | |||||||||||
Foreign government securities | 313 | — | 313 | — | |||||||||||
Total fixed-maturity securities | 9,711 | — | 8,981 | 730 | |||||||||||
Short-term investments | 904 | 506 | 398 | — | |||||||||||
Other invested assets(1) | 127 | — | 119 | 8 | |||||||||||
Credit derivative assets | 94 | — | — | 94 | |||||||||||
FG VIEs’ assets, at fair value | 2,565 | — | — | 2,565 | |||||||||||
Other assets | 84 | 27 | 11 | 46 | |||||||||||
Total assets carried at fair value | $ | 13,485 | $ | 533 | $ | 9,509 | $ | 3,443 | |||||||
Liabilities: | |||||||||||||||
Credit derivative liabilities | $ | 1,787 | $ | — | $ | — | $ | 1,787 | |||||||
FG VIEs’ liabilities with recourse, at fair value | 1,790 | — | — | 1,790 | |||||||||||
FG VIEs’ liabilities without recourse, at fair value | 1,081 | — | — | 1,081 | |||||||||||
Total liabilities carried at fair value | $ | 4,658 | $ | — | $ | — | $ | 4,658 | |||||||
____________________
(1) | Includes Level 3 mortgage loans that are recorded at fair value on a non-recurring basis. |
(2) | Exclude restricted cash. |
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Changes in Level 3 Fair Value Measurements
The table below presents a roll forward of the Company’s Level 3 financial instruments carried at fair value on a recurring basis during the years ended December 31, 2014 and 2013.
Fair Value Level 3 Rollforward
Recurring Basis
Year Ended December 31, 2014
Fixed-Maturity Securities | |||||||||||||||||||||||||||||||||||||||||||||||||
Obligations of State and Political Subdivisions | Corporate Securities | RMBS | Asset- Backed Securities | Other Invested Assets | FG VIEs’ Assets at Fair Value | Other Assets | Credit Derivative Asset (Liability), net(5) | FG VIEs' Liabilities with Recourse, at Fair Value | FG VIEs’ Liabilities without Recourse, at Fair Value | ||||||||||||||||||||||||||||||||||||||||
(in millions) | |||||||||||||||||||||||||||||||||||||||||||||||||
Fair value as of December 31, 2013 | $ | 36 | $ | 136 | $ | 290 | $ | 268 | $ | 2 | $ | 2,565 | $ | 46 | $ | (1,693 | ) | $ | (1,790 | ) | $ | (1,081 | ) | ||||||||||||||||||||||||||
Total pretax realized and unrealized gains/(losses) recorded in:(1) | |||||||||||||||||||||||||||||||||||||||||||||||||
Net income (loss) | 4 | (2 | ) | (46 | ) | (2 | ) | 21 | (2 | ) | 17 | (2 | ) | — | 164 | (3 | ) | (11 | ) | (4 | ) | 823 | (6 | ) | 94 | (3 | ) | (43 | ) | (3 | ) | ||||||||||||||||||
Other comprehensive income (loss) | (1 | ) | (6 | ) | 24 | 5 | 6 | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||
Purchases | — | — | 263 | — | 70 | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||
Settlements | (1 | ) | (5 | ) | (59 | ) | (62 | ) | 0 | (408 | ) | — | (25 | ) | 374 | 22 | |||||||||||||||||||||||||||||||||
FG VIE consolidations | — | — | (127 | ) | — | — | 206 | — | — | (189 | ) | (42 | ) | ||||||||||||||||||||||||||||||||||||
FG VIE deconsolidations | — | — | 13 | — | — | (1,129 | ) | — | — | 234 | 1,002 | ||||||||||||||||||||||||||||||||||||||
Fair value as of December 31, 2014 | $ | 38 | $ | 79 | $ | 425 | $ | 228 | $ | 78 | $ | 1,398 | $ | 35 | $ | (895 | ) | $ | (1,277 | ) | $ | (142 | ) | ||||||||||||||||||||||||||
Change in unrealized gains/(losses) related to financial instruments held as of December 31, 2014 | $ | (1 | ) | $ | (6 | ) | $ | 21 | $ | 4 | $ | 6 | $ | 141 | $ | (11 | ) | $ | 254 | $ | (22 | ) | $ | 3 | |||||||||||||||||||||||||
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Fair Value Level 3 Rollforward
Recurring Basis
Year Ended December 31, 2013
Fixed-Maturity Securities | ||||||||||||||||||||||||||||||||||||||||||||||||||
Obligations of state and political subdivisions | Corporate Securities | RMBS | Asset Backed Securities | Other Invested Assets | FG VIEs’ Assets at Fair Value | Other Assets | Credit Derivative Asset (Liability), net(5) | FG VIEs’ Liabilities with Recourse, at Fair Value | FG VIEs’ Liabilities without Recourse, at Fair Value | |||||||||||||||||||||||||||||||||||||||||
(in millions) | ||||||||||||||||||||||||||||||||||||||||||||||||||
Fair value as of December 31, 2012 | $ | 35 | $ | — | $ | 219 | $ | 306 | $ | 1 | $ | 2,688 | $ | 36 | $ | (1,793 | ) | $ | (2,090 | ) | $ | (1,051 | ) | |||||||||||||||||||||||||||
Total pretax realized and unrealized gains/(losses) recorded in:(1) | ||||||||||||||||||||||||||||||||||||||||||||||||||
Net income (loss) | (8 | ) | (2 | ) | 4 | (2 | ) | 13 | (2 | ) | 67 | (2 | ) | (1 | ) | (7 | ) | 686 | (3 | ) | 10 | (4 | ) | 65 | (6 | ) | (166 | ) | (3 | ) | (225 | ) | (3 | ) | ||||||||||||||||
Other comprehensive income (loss) | 13 | 5 | 26 | (43 | ) | 2 | — | — | — | — | — | |||||||||||||||||||||||||||||||||||||||
Purchases | — | 130 | (8 | ) | 86 | 80 | 2 | (8 | ) | — | — | — | — | — | ||||||||||||||||||||||||||||||||||||
Settlements | (4 | ) | (3 | ) | (54 | ) | (142 | ) | (2 | ) | (663 | ) | — | 35 | 343 | 168 | ||||||||||||||||||||||||||||||||||
FG VIE consolidations | — | — | — | — | — | 48 | — | — | (12 | ) | (37 | ) | ||||||||||||||||||||||||||||||||||||||
FG VIE deconsolidations | — | — | — | — | — | (194 | ) | — | — | 135 | 64 | |||||||||||||||||||||||||||||||||||||||
Fair value as of December 31, 2013 | $ | 36 | $ | 136 | $ | 290 | $ | 268 | $ | 2 | $ | 2,565 | $ | 46 | $ | (1,693 | ) | $ | (1,790 | ) | $ | (1,081 | ) | |||||||||||||||||||||||||||
Change in unrealized gains/(losses) related to financial instruments held as of December 31, 2013 | $ | 14 | $ | 5 | $ | 27 | $ | (20 | ) | $ | 2 | $ | 623 | $ | 10 | $ | (139 | ) | $ | (169 | ) | $ | (326 | ) | ||||||||||||||||||||||||||
___________________
(1) | Realized and unrealized gains (losses) from changes in values of Level 3 financial instruments represent gains (losses) from changes in values of those financial instruments only for the periods in which the instruments were classified as Level 3. |
(2) | Included in net realized investment gains (losses) and net investment income. |
(3) | Included in fair value gains (losses) on FG VIEs. |
(4) | Recorded in fair value gains (losses) on CCS. |
(5) | Represents net position of credit derivatives. The consolidated balance sheet presents gross assets and liabilities based on net counterparty exposure. |
(6) | Reported in net change in fair value of credit derivatives. |
(7) | Reported in other income. |
(8) | Non-cash transaction. |
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Level 3 Fair Value Disclosures
Quantitative Information About Level 3 Fair Value Inputs
At December 31, 2014
Financial Instrument Description(1) | Fair Value at December 31, 2014(in millions) | Significant Unobservable Inputs | Range | Weighted Average as a Percentage of Current Par Outstanding | ||||||||||
Assets: | ||||||||||||||
Fixed-maturity securities: | ||||||||||||||
Obligations of state and political subdivisions | $ | 38 | Rate of inflation | 1.0 | % | - | 3.0% | 2.0% | ||||||
Cash flow receipts | 0.5 | % | - | 74.3% | 63.0% | |||||||||
Yield | 4.6 | % | 8.0% | 7.3% | ||||||||||
Collateral recovery period | 1 month | - | 34 years | 28 years | ||||||||||
Corporate securities | 79 | Yield | 17.8% | |||||||||||
RMBS | 425 | CPR | 0.3 | % | - | 8.1% | 3.3% | |||||||
CDR | 2.7 | % | - | 10.6% | 5.3% | |||||||||
Loss severity | 52.6 | % | - | 100.0% | 75.2% | |||||||||
Yield | 4.7 | % | - | 11.7% | 6.4% | |||||||||
Asset-backed securities: | ||||||||||||||
Investor owned utility | 95 | Cash flow receipts | 100.0% | |||||||||||
Collateral recovery period | 4 years | |||||||||||||
Discount factor | 7.0% | |||||||||||||
XXX life insurance transactions | 133 | Yield | 7.3% | |||||||||||
Other invested assets | 83 | Discount for lack of liquidity | 20.0% | |||||||||||
Recovery on delinquent loans | 40.0% | |||||||||||||
Default rates | 0.0 | % | - | 7.0% | 5.8% | |||||||||
Loss severity | 40.0 | % | - | 75.0% | 68.3% | |||||||||
Prepayment speeds | 5.0 | % | - | 15.0% | 12.3% | |||||||||
Net asset value (per share) | $ | 965 | - | $1,159 | $1,082 | |||||||||
FG VIEs’ assets, at fair value | 1,398 | CPR | 0.3 | % | - | 11.0% | 3.3% | |||||||
CDR | 1.6 | % | - | 11.8% | 5.1% | |||||||||
Loss severity | 40.0 | % | - | 100.0% | 82.2% | |||||||||
Yield | 2.7 | % | - | 17.7% | 7.9% | |||||||||
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Financial Instrument Description(1) | Fair Value at December 31, 2014 (in millions) | Significant Unobservable Inputs | Range | Weighted Average as a Percentage of Current Par Outstanding | ||||||||
Other assets | 35 | Quotes from third party pricing | $52 | - | $61 | $57 | ||||||
Term (years) | 5 years | |||||||||||
Liabilities: | ||||||||||||
Credit derivative liabilities, net | (895 | ) | Year 1 loss estimates | 0.0 | % | - | 93.0% | 2.1% | ||||
Hedge cost (in bps) | 20.0 | - | 243.8 | 61.5 | ||||||||
Bank profit (in bps) | 1.0 | - | 994.4 | 127.0 | ||||||||
Internal floor (in bps) | 7.0 | - | 100.0 | 15.9 | ||||||||
Internal credit rating | AAA | - | CCC | AA+ | ||||||||
FG VIEs’ liabilities, at fair value | (1,419 | ) | CPR | 0.3 | % | - | 11.0% | 3.3% | ||||
CDR | 1.6 | % | - | 11.8% | 5.1% | |||||||
Loss severity | 40.0 | % | - | 100.0% | 82.2% | |||||||
Yield | 2.7 | % | - | 17.7% | 5.8% | |||||||
____________________
(1) | Discounted cash flow is used as valuation technique for all financial instruments. |
205
Quantitative Information About Level 3 Fair Value Inputs
At December 31, 2013
Financial Instrument Description(1) | Fair Value at December 31, 2013(in millions) | Significant Unobservable Inputs | Range | Weighted Average as a Percentage of Current Par Outstanding | ||||||||||
Assets: | ||||||||||||||
Fixed-maturity securities: | ||||||||||||||
Obligations of state and political subdivisions | $ | 36 | Rate of inflation | 1.0 | % | - | 3.0% | 2.0% | ||||||
Cash flow receipts | 0.5 | % | - | 60.9% | 51.1% | |||||||||
Discount rates | 4.6 | % | - | 9.0% | 8.0% | |||||||||
Collateral recovery period | 1 month | - | 10 years | 3 years | ||||||||||
Corporate securities | 136 | Yield | 8.3% | |||||||||||
RMBS | 290 | CPR | 1.0 | % | - | 15.8% | 4.1% | |||||||
CDR | 5.0 | % | - | 25.8% | 17.9% | |||||||||
Loss severity | 48.1 | % | - | 102.5% | 87.2% | |||||||||
Yield | 2.5 | % | - | 9.4% | 5.7% | |||||||||
Asset-backed securities: | ||||||||||||||
Investor owned utility | 141 | Liquidation value (in millions) | $195 | - | $245 | $228 | ||||||||
Years to liquidation | 0 years | - | 3 years | 2 years | ||||||||||
Collateral recovery period | 12 months | - | 6 years | 3.5 years | ||||||||||
Discount factor | 15.3% | |||||||||||||
XXX life insurance transactions | 127 | Yield | 12.5% | |||||||||||
Other invested assets | 8 | Discount for lack of liquidity | 10.0 | % | - | 20.0% | 20.0% | |||||||
Recovery on delinquent loans | 20.0 | % | - | 60.0% | 40.0% | |||||||||
Default rates | 1.0 | % | - | 10.0% | 3.2% | |||||||||
Loss severity | 40.0 | % | - | 90.0% | 73.5% | |||||||||
Prepayment speeds | 6.0 | % | - | 15.0% | 13.1% | |||||||||
FG VIEs’ assets, at fair value | 2,565 | CPR | 0.3 | % | - | 11.8% | 3.6% | |||||||
CDR | 3.0 | % | - | 25.8% | 13.6% | |||||||||
Loss severity | 37.5 | % | - | 102.0% | 94.6% | |||||||||
Yield | 3.5 | % | - | 10.2% | 5.4% | |||||||||
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Financial Instrument Description(1) | Fair Value at December 31, 2013 (in millions) | Significant Unobservable Inputs | Range | Weighted Average as a Percentage of Current Par Outstanding | ||||||||
Other assets | 46 | Quotes from third party pricing | $47 | - | $53 | $50 | ||||||
Term (years) | 5 years | |||||||||||
Liabilities: | ||||||||||||
Credit derivative liabilities, net | (1,693 | ) | Year 1 loss estimates | 0.0 | % | - | 48.0% | 1.9% | ||||
Hedge cost (in bps) | 46.3 | - | 525.0 | 110.1 | ||||||||
Bank profit (in bps) | 1.0 | - | 1,418.5 | 250.4 | ||||||||
Internal floor (in bps) | 7.0 | - | 100.0 | 15.6 | ||||||||
Internal credit rating | AAA | - | CCC | AA+ | ||||||||
FG VIEs’ liabilities, at fair value | (2,871 | ) | CPR | 0.3 | % | - | 11.8% | 3.6% | ||||
CDR | 3.0 | % | - | 25.8% | 13.6% | |||||||
Loss severity | 37.5 | % | - | 102.0% | 94.6% | |||||||
Yield | 3.5 | % | - | 10.2% | 5.4% | |||||||
____________________
(1) | Discounted cash flow is used as valuation technique for all financial instruments. |
The carrying amount and estimated fair value of the Company’s financial instruments are presented in the following table.
Fair Value of Financial Instruments
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||
Carrying Amount | Estimated Fair Value | Carrying Amount | Estimated Fair Value | ||||||||||||
(in millions) | |||||||||||||||
Assets: | |||||||||||||||
Fixed-maturity securities | $ | 10,491 | $ | 10,491 | $ | 9,711 | $ | 9,711 | |||||||
Short-term investments | 767 | 767 | 904 | 904 | |||||||||||
Other invested assets | 108 | 110 | 147 | 155 | |||||||||||
Credit derivative assets | 68 | 68 | 94 | 94 | |||||||||||
FG VIEs’ assets, at fair value | 1,398 | 1,398 | 2,565 | 2,565 | |||||||||||
Other assets | 184 | 184 | 179 | 179 | |||||||||||
Liabilities: | |||||||||||||||
Financial guaranty insurance contracts(1) | 3,823 | 6,205 | 3,783 | 5,128 | |||||||||||
Long-term debt | 1,303 | 1,603 | 816 | 970 | |||||||||||
Credit derivative liabilities | 963 | 963 | 1,787 | 1,787 | |||||||||||
FG VIEs’ liabilities with recourse, at fair value | 1,277 | 1,277 | 1,790 | 1,790 | |||||||||||
FG VIEs’ liabilities without recourse, at fair value | 142 | 142 | 1,081 | 1,081 | |||||||||||
Other liabilities | 27 | 27 | 36 | 36 | |||||||||||
____________________
(1) | Carrying amount includes the assets and liabilities related to financial guaranty insurance contract premiums, losses, and salvage and subrogation and other recoverables net of reinsurance. |
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9. | Financial Guaranty Contracts Accounted for as Credit Derivatives |
Accounting Policy
Credit derivatives are recorded at fair value. Changes in fair value are recorded in “net change in fair value of credit derivatives” on the consolidated statement of operations. Realized gains and other settlements on credit derivatives include credit derivative premiums received and receivable for credit protection the Company has sold under its insured CDS contracts, premiums paid and payable for credit protection the Company has purchased, claims paid and payable and received and receivable related to insured credit events under these contracts, ceding commissions expense or income and realized gains or losses related to their early termination. Fair value of credit derivatives is reflected as either net assets or net liabilities determined on a contract by contract basis in the Company's consolidated balance sheets. See Note 8, Fair Value Measurement, for a discussion on the fair value methodology for credit derivatives.
Credit Derivatives
The Company has a portfolio of financial guaranty contracts that meet the definition of a derivative in accordance with GAAP (primarily CDS).
Credit derivative transactions are governed by ISDA documentation and have different characteristics from financial guaranty insurance contracts. For example, the Company’s control rights with respect to a reference obligation under a credit derivative may be more limited than when the Company issues a financial guaranty insurance contract. In addition, there are more circumstances under which the Company may be obligated to make payments. Similar to a financial guaranty insurance contract, the Company would be obligated to pay if the obligor failed to make a scheduled payment of principal or interest in full. However, the Company may also be required to pay if the obligor becomes bankrupt or if the reference obligation were restructured if, after negotiation, those credit events are specified in the documentation for the credit derivative transactions. Furthermore, the Company may be required to make a payment due to an event that is unrelated to the performance of the obligation referenced in the credit derivative. If events of default or termination events specified in the credit derivative documentation were to occur, the non-defaulting or the non-affected party, which may be either the Company or the counterparty, depending upon the circumstances, may decide to terminate a credit derivative prior to maturity. In that case, the Company may be required to make a termination payment to its swap counterparty upon such termination. The Company may not unilaterally terminate a CDS contract; however, the Company on occasion has mutually agreed with various counterparties to terminate certain CDS transactions.
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Credit Derivative Net Par Outstanding by Sector
The estimated remaining weighted average life of credit derivatives was 4.7 years at December 31, 2014 and 4.1 years at December 31, 2013. The components of the Company’s credit derivative net par outstanding are presented below.
Credit Derivatives
Subordination and Ratings
As of December 31, 2014 | As of December 31, 2013 | |||||||||||||||||||||||
Asset Type | Net Par Outstanding | Original Subordination(1) | Current Subordination(1) | Weighted Average Credit Rating | Net Par Outstanding | Original Subordination(1) | Current Subordination(1) | Weighted Average Credit Rating | ||||||||||||||||
(dollars in millions) | ||||||||||||||||||||||||
Pooled corporate obligations: | ||||||||||||||||||||||||
Collateralized loan obligation/collateral bond obligations | $ | 11,688 | 32.0 | % | 36.9 | % | AAA | $ | 19,323 | 32.4 | % | 34.0 | % | AAA | ||||||||||
Synthetic investment grade pooled corporate | 7,640 | 22.6 | 20.6 | AAA | 9,754 | 21.6 | 20.0 | AAA | ||||||||||||||||
Synthetic high yield pooled corporate | — | — | — | — | 2,690 | 47.2 | 41.1 | AAA | ||||||||||||||||
TruPS CDOs | 3,119 | 45.3 | 35.8 | BBB- | 3,554 | 45.5 | 32.9 | BB+ | ||||||||||||||||
Market value CDOs of corporate obligations | 1,174 | 19.1 | 20.7 | AAA | 2,000 | 24.4 | 30.5 | AAA | ||||||||||||||||
Total pooled corporate obligations | 23,621 | 30.1 | 30.7 | AAA | 37,321 | 31.5 | 30.6 | AAA | ||||||||||||||||
U.S. RMBS: | ||||||||||||||||||||||||
Option ARM and Alt-A first lien | 1,378 | 16.3 | 10.7 | BB+ | 2,609 | 19.2 | 8.6 | BB- | ||||||||||||||||
Subprime first lien | 1,366 | 31.1 | 50.5 | A | 2,930 | 30.5 | 51.9 | AA- | ||||||||||||||||
Prime first lien | 223 | 10.9 | 0.0 | B | 264 | 10.9 | 3.2 | CCC | ||||||||||||||||
Closed-end second lien | 19 | — | — | CCC | 23 | — | — | B+ | ||||||||||||||||
Total U.S. RMBS | 2,986 | 24.8 | 33.9 | BBB | 5,826 | 24.4 | 30.1 | BBB | ||||||||||||||||
CMBS | 1,952 | 35.3 | 43.6 | AAA | 3,744 | 33.5 | 42.5 | AAA | ||||||||||||||||
Other | 6,437 | — | — | A | 7,591 | — | — | A- | ||||||||||||||||
Total | $ | 34,996 | AA+ | $ | 54,482 | AA+ | ||||||||||||||||||
____________________
(1) | Represents the sum of subordinate tranches and over-collateralization and does not include any benefit from excess interest collections that may be used to absorb losses. |
Except for TruPS CDOs, the Company’s exposure to pooled corporate obligations is highly diversified in terms of obligors and industries. Most pooled corporate transactions are structured to limit exposure to any given obligor and industry. The majority of the Company’s pooled corporate exposure consists of collateralized loan obligation (“CLO”) or synthetic pooled corporate obligations. Most of these CLOs have an average obligor size of less than 1% of the total transaction and typically restrict the maximum exposure to any one industry to approximately 10%. The Company’s exposure also benefits from embedded credit enhancement in the transactions which allows a transaction to sustain a certain level of losses in the underlying collateral, further insulating the Company from industry specific concentrations of credit risk on these deals.
The Company’s TruPS CDO asset pools are generally less diversified by obligors and industries than the typical CLO asset pool. Also, the underlying collateral in TruPS CDOs consists primarily of subordinated debt instruments such as TruPS issued by bank holding companies and similar instruments issued by insurance companies, REITs and other real estate related issuers while CLOs typically contain primarily senior secured obligations. However, to mitigate these risks TruPS CDOs were typically structured with higher levels of embedded credit enhancement than typical CLOs.
The Company’s exposure to “Other” CDS contracts is also highly diversified. It includes $2.0 billion of exposure to one pooled infrastructure transaction comprising diversified pools of international infrastructure project transactions and loans
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to regulated utilities. These pools were all structured with underlying credit enhancement sufficient for the Company to attach at AAA levels at origination. The remaining $4.4 billion of exposure in “Other” CDS contracts comprises numerous deals across various asset classes, such as commercial receivables, international RMBS, infrastructure, regulated utilities and consumer receivables.
Distribution of Credit Derivative Net Par Outstanding by Internal Rating
As of December 31, 2014 | As of December 31, 2013 | |||||||||||||
Ratings | Net Par Outstanding | % of Total | Net Par Outstanding | % of Total | ||||||||||
(dollars in millions) | ||||||||||||||
AAA | $ | 21,817 | 62.3 | % | $ | 38,244 | 70.2 | % | ||||||
AA | 5,398 | 15.4 | 3,648 | 6.7 | ||||||||||
A | 1,982 | 5.7 | 3,636 | 6.7 | ||||||||||
BBB | 2,774 | 8.0 | 4,161 | 7.6 | ||||||||||
BIG | 3,025 | 8.6 | 4,793 | 8.8 | ||||||||||
Credit derivative net par outstanding | $ | 34,996 | 100.0 | % | $ | 54,482 | 100.0 | % | ||||||
Fair Value of Credit Derivatives
Net Change in Fair Value of Credit Derivatives Gain (Loss)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Realized gains on credit derivatives | $ | 73 | $ | 121 | $ | 128 | |||||
Net credit derivative losses (paid and payable) recovered and recoverable and other settlements | (50 | ) | (163 | ) | (236 | ) | |||||
Realized gains (losses) and other settlements on credit derivatives | 23 | (42 | ) | (108 | ) | ||||||
Net change in unrealized gains (losses) on credit derivatives: | |||||||||||
Pooled corporate obligations | (18 | ) | (32 | ) | 59 | ||||||
U.S. RMBS | 814 | (69 | ) | (551 | ) | ||||||
CMBS | 2 | — | 2 | ||||||||
Other(1) | 2 | 208 | 13 | ||||||||
Net change in unrealized gains (losses) on credit derivatives(2) | 800 | 107 | (477 | ) | |||||||
Net change in fair value of credit derivatives | $ | 823 | $ | 65 | $ | (585 | ) | ||||
____________________
(1) | “Other” includes all other U.S. and international asset classes, such as commercial receivables, international infrastructure, international RMBS securities, and pooled infrastructure securities. |
(2) | Except for net estimated credit impairments (i.e., net expected loss to be paid as discussed in Note 6), the unrealized gains and losses on credit derivatives are expected to reduce to zero as the exposure approaches its maturity date. With considerable volatility continuing in the market, unrealized gains (losses) on credit derivatives may fluctuate significantly in future periods. |
The table below sets out the net par amount of credit derivative contracts that the Company and its counterparties agreed to terminate on a consensual basis.
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Net Par and Realized Gains (Losses) on Credit Derivatives
from Terminations of CDS Contracts
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Net par of terminated CDS contracts | $ | 3,591 | $ | 4,054 | $ | 2,264 | |||||
Realized gains (losses) and other settlements | 1 | 21 | 3 | ||||||||
During 2014, unrealized fair value gains were generated primarily in the U.S. RMBS prime first lien, Option ARM and subprime sectors. This is primarily due to a significant unrealized fair value gain in the Option ARM and Alt-A first lien sector of approximately $543 million, as a result of the terminations of three large Alt-A first lien resecuritization transactions and one Option ARM first lien transaction during the period. In addition, there was an unrealized gain of approximately $346 million related to the change in index used to determine fair value during the fourth quarter of 2014. In the fourth quarter of 2014, new market indices were published on Option ARM and Alt-A first lien securitizations. As part of the Company’s normal review process the Company reviewed these indices and based upon the collateral make-up, collateral vintage, and collateral loss experience, determined it to be a better market indication for the Company’s Option ARM and Alt-A first lien securitizations. The unrealized fair value gains were partially offset by unrealized fair value losses generated by wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s and AGM’s name, as the market cost of AGC's and AGM’s credit protection decreased during the period. These transactions were pricing at or above their floor levels (or the minimum rate at which the Company would consider assuming these risks based on historical experience); therefore when the cost of purchasing CDS protection on AGC and AGM, which management refers to as the CDS spread on AGC and AGM, decreased the implied spreads that the Company would expect to receive on these transactions increased.
During 2013, unrealized fair value gains were generated in the “other” sector primarily as a result of the termination of a film securitization transaction and a U.K. infrastructure transaction, as well as price improvement on a XXX life securitization transaction. These unrealized gains were partially offset by unrealized fair value losses in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors due to wider implied net spreads. The wider implied net spreads were primarily a result of the decreased cost to buy protection in AGC’s name as the market cost of AGC’s credit protection decreased. These transactions were pricing above their floor levels; therefore when the cost of purchasing CDS protection on AGC, decreased the implied spreads that the Company would expect to receive on these transactions increased. The cost of AGM’s credit protection also decreased slightly during 2013, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels. The company terminated a film securitization CDS for a payment of $120 million which was recorded in realized gains (losses) and other settlements on credit derivatives, with a corresponding release of the unrealized loss recorded in unrealized gains (losses) on credit derivatives of $127 million for a net change in fair value of credit derivatives of $7 million.
During 2012, U.S. RMBS unrealized fair value losses were generated primarily in the prime first lien, Alt-A, Option ARM and subprime RMBS sectors primarily as a result of the decreased cost to buy protection in AGC's name as the market cost of AGC's credit protection decreased. These transactions were pricing above their floor levels therefore when the cost of purchasing CDS protection on AGC decreased, the implied spreads that the Company would expect to receive on these transactions increased. The cost of AGM's credit protection also decreased during 2012, but did not lead to significant fair value losses, as the majority of AGM policies continue to price at floor levels. In addition, 2012 included an $85 million unrealized gain relating to R&W benefits from the agreement with Deutsche Bank.
The impact of changes in credit spreads will vary based upon the volume, tenor, interest rates, and other market conditions at the time these fair values are determined. In addition, since each transaction has unique collateral and structural terms, the underlying change in fair value of each transaction may vary considerably. The fair value of credit derivative contracts also reflects the change in the Company’s own credit cost based on the price to purchase credit protection on AGC and AGM. The Company determines its own credit risk based on quoted CDS prices traded on the Company at each balance sheet date.
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Five-Year CDS Spread
on AGC and AGM
Quoted price of CDS contract (in basis points)
As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | ||||||
AGC | 323 | 460 | 678 | |||||
AGM | 325 | 525 | 536 | |||||
One-Year CDS Spread
on AGC and AGM
Quoted price of CDS contract (in basis points)
As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2012 | ||||||
AGC | 80 | 185 | 270 | |||||
AGM | 85 | 220 | 257 | |||||
Fair Value of Credit Derivatives Assets (Liabilities)
and Effect of AGC and AGM
Credit Spreads
As of December 31, 2014 | As of December 31, 2013 | ||||||
(in millions) | |||||||
Fair value of credit derivatives before effect of AGC and AGM credit spreads | $ | (2,029 | ) | $ | (3,442 | ) | |
Plus: Effect of AGC and AGM credit spreads | 1,134 | 1,749 | |||||
Net fair value of credit derivatives | $ | (895 | ) | $ | (1,693 | ) | |
The fair value of CDS contracts at December 31, 2014, before considering the implications of AGC’s and AGM’s credit spreads, is a direct result of continued wide credit spreads in the fixed income security markets and ratings downgrades. The asset classes that remain most affected are 2005-2007 vintages of prime first lien, Alt-A, Option ARM, subprime RMBS deals as well as trust-preferred and pooled corporate securities. Comparing December 31, 2014 with December 31, 2013,there was a narrowing of spreads primarily related to Alt-A first lien, Option ARM, and subprime RMBS transactions, as well as the Company's pooled corporate obligations. This narrowing of spreads combined with the runoff of par outstanding and termination of CDS contracts, resulted in a gain of approximately $1,413 million, before taking into account AGC’s or AGM’s credit spreads.
Management believes that the trading level of AGC’s and AGM’s credit spreads over the past several years has been due to the correlation between AGC’s and AGM’s risk profile and the current risk profile of the broader financial markets and to increased demand for credit protection against AGC and AGM as the result of its financial guaranty volume, as well as the overall lack of liquidity in the CDS market. Offsetting the benefit attributable to AGC’s and AGM’s credit spread were higher credit spreads in the fixed income security markets. The higher credit spreads in the fixed income security market are due to the lack of liquidity in the high yield CDO, TruPS CDO, and CLO markets as well as continuing market concerns over the 2005-2007 vintages of RMBS.
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The following table presents the fair value and the present value of expected claim payments or recoveries (i.e., net expected loss to be paid as described in Note 6) for contracts accounted for as derivatives.
Net Fair Value and Expected Losses
Credit Derivatives by Sector
Fair Value of Credit Derivative Asset (Liability), net | Expected Loss to be (Paid) Recovered (1) | |||||||||||||||
Asset Type | As of December 31, 2014 | As of December 31, 2013 | As of December 31, 2014 | As of December 31, 2013 | ||||||||||||
(in millions) | ||||||||||||||||
Pooled corporate obligations | $ | (49 | ) | $ | (30 | ) | $ | (23 | ) | $ | (48 | ) | ||||
U.S. RMBS | (494 | ) | (1,308 | ) | (73 | ) | (175 | ) | ||||||||
CMBS | 0 | (2 | ) | — | — | |||||||||||
Other | (352 | ) | (353 | ) | 38 | 39 | ||||||||||
Total | $ | (895 | ) | $ | (1,693 | ) | $ | (58 | ) | $ | (184 | ) | ||||
____________________
(1) | Includes R&W benefit of $86 million as of December 31, 2014 and $180 million as of December 31, 2013. |
Ratings Sensitivities of Credit Derivative Contracts
Within the Company’s insured CDS portfolio, the transaction documentation for approximately $6.1 billion in CDS gross par insured as of December 31, 2014 requires AGC and Assured Guaranty Re Overseas Ltd. ("AGRO") to post eligible collateral to secure its obligations to make payments under such contracts. Eligible collateral is generally cash or U.S. government or agency securities; eligible collateral other than cash is valued at a discount to the face amount.
• | For approximately $5.9 billion of such contracts, AGC has negotiated caps such that the posting requirement cannot exceed a certain fixed amount, regardless of the mark-to-market valuation of the exposure or the financial strength ratings of AGC. For such contracts, AGC need not post on a cash basis more than $665 million, although the value of the collateral posted may exceed such fixed amount depending on the advance rate agreed with the counterparty for the particular type of collateral posted. |
• | For the remaining approximately $242 million of such contracts, AGC or AGRO could be required from time to time to post additional collateral without such cap based on movements in the mark-to-market valuation of the underlying exposure. |
As of December 31, 2014, the Company posted approximately $376 million to secure obligations under its CDS exposure, of which approximately $25 million related to such $242 million of notional. As of December 31, 2013, the Company posted approximately $677 million, of which approximately $62 million related to $347 million of notional where AGC or AGRO could be required to post additional collateral based on movements in the mark-to-market valuation of the underlying exposure.
On May 6, 2014, AGC’s affiliate AG Financial Products Inc. and one of its CDS counterparties amended the ISDA master agreement between them, at no cost, to remove a termination trigger based on a rating downgrade of the other party. With this termination, none of the Company's insured CDS portfolio is subject to a rating-based termination trigger that could result in the Company being obligated to make a termination payment to a CDS counterparty.
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Sensitivity to Changes in Credit Spread
The following table summarizes the estimated change in fair values on the net balance of the Company’s credit derivative positions assuming immediate parallel shifts in credit spreads on AGC and AGM and on the risks that they both assume.
Effect of Changes in Credit Spread
As of December 31, 2014
Credit Spreads(1) | Estimated Net Fair Value (Pre-Tax) | Estimated Change in Gain/(Loss) (Pre-Tax) | ||||||
(in millions) | ||||||||
100% widening in spreads | $ | (1,821 | ) | $ | (926 | ) | ||
50% widening in spreads | (1,358 | ) | (463 | ) | ||||
25% widening in spreads | (1,128 | ) | (233 | ) | ||||
10% widening in spreads | (989 | ) | (94 | ) | ||||
Base Scenario | (895 | ) | — | |||||
10% narrowing in spreads | (809 | ) | 86 | |||||
25% narrowing in spreads | (679 | ) | 216 | |||||
50% narrowing in spreads | (466 | ) | 429 | |||||
____________________
(1) | Includes the effects of spreads on both the underlying asset classes and the Company’s own credit spread. |
10. | Consolidated Variable Interest Entities |
The Company provides financial guaranties with respect to debt obligations of special purpose entities, including VIEs. AGC and AGM do not sponsor any VIEs when underwriting third party financial guaranty insurance or credit derivative transactions, nor has either of them acted as the servicer or collateral manager for any VIE obligations that it insures. The transaction structure generally provides certain financial protections to the Company. This financial protection can take several forms, the most common of which are overcollateralization, first loss protection (or subordination) and excess spread. In the case of overcollateralization (i.e., the principal amount of the securitized assets exceeds the principal amount of the structured finance obligations guaranteed by the Company), the structure allows defaults of the securitized assets before a default is experienced on the structured finance obligation guaranteed by the Company. In the case of first loss, the financial guaranty insurance policy only covers a senior layer of losses experienced by multiple obligations issued by special purpose entities, including VIEs. The first loss exposure with respect to the assets is either retained by the seller or sold off in the form of equity or mezzanine debt to other investors. In the case of excess spread, the financial assets contributed to special purpose entities, including VIEs, generate cash flows that are in excess of the interest payments on the debt issued by the special purpose entity. Such excess spread is typically distributed through the transaction’s cash flow waterfall and may be used to create additional credit enhancement, applied to redeem debt issued by the special purpose entities, including VIEs (thereby, creating additional overcollateralization), or distributed to equity or other investors in the transaction.
AGC and AGM are not primarily liable for the debt obligations issued by the VIEs they insure and would only be required to make payments on those insured debt obligations in the event that the issuer of such debt obligations defaults on any principal or interest due and only for the amount of the shortfall. AGL’s and its Subsidiaries’ creditors do not have any rights with regard to the collateral supporting the debt issued by the FG VIEs. Proceeds from sales, maturities, prepayments and interest from such underlying collateral may only be used to pay Debt Service on VIE liabilities. Net fair value gains and losses on FG VIEs are expected to reverse to zero at maturity of the VIE debt, except for net premiums received and net claims paid by AGC or AGM under the financial guaranty insurance contract. The Company’s estimate of expected loss to be paid for FG VIEs is included in Note 6, Expected Loss to be Paid.
Accounting Policy
The Company evaluates whether it is the primary beneficiary of its VIEs. If the Company concludes that it is the primary beneficiary, it is required to consolidate the entire VIE in the Company's financial statements and eliminate the effects of the financial guaranty insurance contracts issued by AGM and AGC on the consolidated FG VIEs debt obligations.
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The primary beneficiary of a VIE is the enterprise that has both 1) the power to direct the activities of a VIE that most significantly impact the entity's economic performance; and 2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE.
As part of the terms of its financial guaranty contracts, the Company obtains certain protective rights with respect to the VIE that are triggered by the occurrence of certain events, such as failure to be in compliance with a covenant due to poor deal performance or a deterioration in a servicer or collateral manager's financial condition. At deal inception, the Company typically is not deemed to control a VIE; however, once a trigger event occurs, the Company's control of the VIE typically increases. The Company continuously evaluates its power to direct the activities that most significantly impact the economic performance of VIEs that have debt obligations insured by the Company and, accordingly, where the Company is obligated to absorb VIE losses or receive benefits that could potentially be significant to the VIE. The Company obtains protective rights under its insurance contracts that give the Company additional controls over a VIE if there is either deterioration of deal performance or in the financial health of the deal servicer. The Company is deemed to be the control party for certain VIEs under GAAP, typically when its protective rights give it the power to both terminate and replace the deal servicer, which are characteristics specific to the Company's financial guaranty contracts. If the protective rights that could make the Company the control party have not been triggered, then the VIE is not consolidated. If the Company is deemed no longer to have those protective rights, the transaction is deconsolidated.
The FG VIEs' liabilities that are insured by the Company are considered to be with recourse, because the Company guarantees the payment of principal and interest regardless of the performance of the related FG VIEs' assets. FG VIEs' liabilities that are not insured by the Company are considered to be without recourse, because the payment of principal and interest of these liabilities is wholly dependent on the performance of the FG VIEs' assets.
The Company has limited contractual rights to obtain the financial records of its consolidated FG VIEs. The FG VIEs do not prepare separate GAAP financial statements; therefore, the Company compiles GAAP financial information for them based on trustee reports prepared by and received from third parties. Such trustee reports are not available to the Company until approximately 30 days after the end of any given period. The time required to perform adequate reconciliations and analyses of the information in these trustee reports results in a one quarter lag in reporting the FG VIEs' activities. The Company records the fair value of FG VIE assets and liabilities based on modeled prices. The Company updates the model assumptions each reporting period for the most recent available information, which incorporates the impact of material events that may have occurred since the quarter lag date. Interest income and interest expense are derived from the trustee reports and included in “fair value gains (losses) on FG VIEs” in the consolidated statement of operations. The Company has elected the fair value option for assets and liabilities classified as FG VIEs' assets and liabilities because the carrying amount transition method was not practical.
The cash flows generated by the FG VIE assets, including R&W recoveries, are classified as cash flows from investing activities. Paydowns of FG liabilities are supported by the cash flows generated by FG VIE assets, and for liabilities with recourse, possibly claim payments made by AGM or AGC under its financial guaranty insurance contracts. Paydowns of FG liabilities both with and without recourse are classified as cash flows used in financing activities by the Company. Interest income, interest expense and other expenses of the FG VIE assets and liabilities are classified as operating cash flows. Claim payments made by AGC and AGM under the financial guaranty contracts issued to the FG VIEs are eliminated upon consolidation and therefore such claim payments are treated as paydowns of FG VIE liabilities as a financing activity as opposed to an operating activity of AGM and AGC.
215
Consolidated FG VIEs
Number of FG VIEs Consolidated
Year Ended December 31, | ||||||||
2014 | 2013 | 2012 | ||||||
Beginning of the period, December 31 | 40 | 33 | 33 | |||||
Consolidated(1) | 2 | 11 | 2 | |||||
Deconsolidated(1) | (8 | ) | (3 | ) | — | |||
Matured | (2 | ) | (1 | ) | (2 | ) | ||
End of the period, December 31 | 32 | 40 | 33 | |||||
____________________
(1) | Net gain on deconsolidation was $120 million and net loss on consolidation was $26 million in 2014. Net loss on consolidation and deconsolidation was $7 million in 2013 and $6 million in 2012, respectively, and recorded in “fair value gains (losses) on FG VIEs” in the consolidated statement of operations. |
The total unpaid principal balance for the FG VIEs’ assets that were over 90 days or more past due was approximately $183 million at December 31, 2014 and $750 million at December 31, 2013. The aggregate unpaid principal of the FG VIEs’ assets was approximately $941 million greater than the aggregate fair value at December 31, 2014, excluding the effect of R&W settlements. The aggregate unpaid principal of the FG VIEs’ assets was approximately $1,940 million greater than the aggregate fair value at December 31, 2013, excluding the effect of R&W settlements. The change in the instrument-specific credit risk of the FG VIEs’ assets held as of December 31, 2014 that was recorded in the consolidated statements of operations for 2014 were gains of $116 million. The change in the instrument-specific credit risk of the FG VIEs’ assets held as of December 31, 2013 that was recorded in the consolidated statements of operations for 2013 were gains of $340 million. The change in the instrument-specific credit risk of the FG VIEs’ assets for 2012 were gains of $413 million. To calculate the instrument specific credit risk, the changes in the fair value of the FG VIE assets are allocated between those changes that are due to the instrument specific credit risk and those are due to other factors, including interest rates. The instrument specific credit risk amount is determined by using expected contractual cash flows vs. current expected cash flows discounted at original contractual rate. The net present value is calculated by discounting the expected cash flows of the underlying security, excluding the Company’s financial guaranty insurance, at the relevant effective interest rate.
The unpaid principal for FG VIE liabilities with recourse was $1,912 million and $2,316 million as of December 31, 2014 and December 31, 2013, respectively. FG VIE liabilities with recourse will mature at various dates ranging from 2025 to 2046. The aggregate unpaid principal balance of the FG VIE liabilities with and without recourse was approximately $916 million greater than the aggregate fair value of the FG VIEs’ liabilities as of December 31, 2014. The aggregate unpaid principal balance was approximately $1,611 million greater than the aggregate fair value of the FG VIEs’ liabilities as of December 31, 2013.
The table below shows the carrying value of the consolidated FG VIEs’ assets and liabilities in the consolidated financial statements, segregated by the types of assets that collateralize their respective debt obligations.
216
Consolidated FG VIEs
By Type of Collateral
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||
Assets | Liabilities | Assets | Liabilities | ||||||||||||
(in millions) | |||||||||||||||
With recourse: | |||||||||||||||
U.S. RMBS first lien | $ | 632 | $ | 581 | $ | 630 | $ | 791 | |||||||
U.S. RMBS second lien | 238 | 327 | 460 | 640 | |||||||||||
Other | 369 | 369 | 359 | 359 | |||||||||||
Total with recourse | 1,239 | 1,277 | 1,449 | 1,790 | |||||||||||
Without recourse | 163 | 142 | 1,116 | 1,081 | |||||||||||
Total | $ | 1,402 | $ | 1,419 | $ | 2,565 | $ | 2,871 | |||||||
The consolidation of FG VIEs has a significant effect on net income and shareholder’s equity due to (1) changes in fair value gains (losses) on FG VIE assets and liabilities, (2) the elimination of premiums and losses related to the AGC and AGM FG VIE liabilities with recourse and (3) the elimination of investment balances related to the Company’s purchase of AGC and AGM insured FG VIE debt. Upon consolidation of a FG VIE, the related insurance and, if applicable, the related investment balances, are considered intercompany transactions and therefore eliminated. Such eliminations are included in the table below to present the full effect of consolidating FG VIEs.
Effect of Consolidating FG VIEs on Net Income,
Cash Flows From Operating Activities and Shareholders’ Equity
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Net earned premiums | $ | (32 | ) | $ | (60 | ) | $ | (153 | ) | ||
Net investment income | (11 | ) | (13 | ) | (13 | ) | |||||
Net realized investment gains (losses) | (5 | ) | 2 | 4 | |||||||
Fair value gains (losses) on FG VIEs | 255 | 346 | 191 | ||||||||
Other income (loss) | (2 | ) | — | — | |||||||
Loss and LAE | 30 | 21 | 65 | ||||||||
Effect on net income before tax | 235 | 296 | 94 | ||||||||
Less: tax provision (benefit) | 82 | 103 | 32 | ||||||||
Effect on net income (loss) | $ | 153 | $ | 193 | $ | 62 | |||||
Effect on cash flows from operating activities | $ | 68 | $ | (136 | ) | $ | 166 | ||||
As of December 31, 2014 | As of December 31, 2013 | ||||||
(in millions) | |||||||
Effect on shareholders’ equity (decrease) increase | $ | (44 | ) | $ | (172 | ) | |
Fair value gains (losses) on FG VIEs represent the net change in fair value on the consolidated FG VIEs’ assets and liabilities. In 2014, the Company recorded a pre-tax net fair value gain on consolidated FG VIEs of $255 million. The primary driver of this gain, $120 million, was a result of the deconsolidation of seven VIEs. In addition, there was gain of $37 million resulting from the Company exercising its option to accelerate two second lien RMBS bonds. The remainder of the gain for the period was driven by the price appreciation on the Company's FG VIE assets during the year resulting from improvements in the underlying collateral, as well as large principal paydowns made on the Company's FG VIEs.
217
In 2013, the Company recorded a pre-tax net fair value gain of consolidated FG VIEs of $346 million. The gain was primarily driven by R&W benefits received on several VIE assets as a result of settlements with various counterparties throughout the year. These R&W settlements resulted in a gain of approximately $265 million. The remainder of the gain was driven by price appreciation on the Company's FG VIE assets during the year resulting from improvements in the underlying collateral, as well as large principal paydowns made on the Company's FG VIEs.
In 2012, the Company recorded a pre-tax fair value gain on FG VIEs of $191 million. The majority of this gain, approximately $166 million, is a result of a R&W benefit received on several VIE assets as a result of a settlement with Deutsche Bank that closed in 2012. While prices continued to appreciate during the period on the Company's FG VIE assets and liabilities, gains in the year were primarily driven by large principal paydowns made on the Company's FG VIEs.
Non-Consolidated VIEs
As of December 31, 2014 and December 31, 2013, the Company had issued financial guaranty contracts for approximately 930 and 1,000 VIEs, respectively, that it did not consolidate. To date, the Company’s analyses have indicated that it does not have a controlling financial interest in any other VIEs and, as a result, they are not consolidated in the consolidated financial statements. The Company’s exposure provided through its financial guaranties with respect to debt obligations of special purpose entities is included within net par outstanding in Note 3, Outstanding Exposure.
11. | Investments and Cash |
Accounting Policy
The vast majority of the Company's investment portfolio is composed of fixed-maturity and short-term investments, classified as available-for-sale at the time of purchase (approximately 99% based on fair value at December 31, 2014), and therefore carried at fair value. Changes in fair value for other-than-temporarily-impaired ("OTTI") securities are bifurcated between credit losses and non-credit changes in fair value. The credit loss on OTTI securities is recorded in the statement of operations and the non-credit component of the change in fair value of securities, whether OTTI or not, is recorded in OCI. For securities where the Company has the intent to sell or it is more-likely-than-not that it will be required to sell the security before recovery, declines in fair value are recorded in the consolidated statements of operations.
Credit losses reduce the amortized cost of impaired securities. The amortized cost basis is adjusted for accretion and amortization (using the effective interest method) with a corresponding entry recorded in net investment income.
Realized gains and losses on sales of investments are determined using the specific identification method. Realized loss includes amounts recorded for other-than-temporary impairments on debt securities and the declines in fair value of securities for which the Company has the intent to sell the security or inability to hold until recovery of amortized cost.
For mortgage‑backed securities, and any other holdings for which there is prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any necessary adjustments due to changes in effective yields and maturities are recognized in net investment income.
The Company purchases securities that it has insured, and for which it has expected losses to be paid, in order to mitigate the economic effect of insured losses ("loss mitigation securities"). These securities were purchased at a discount and are accounted for excluding the effects of the Company’s insurance.
Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at fair value and include amounts deposited in money market funds.
Other invested assets primarily include:
• | preferred stocks, which are carried at fair value with changes in unrealized gains and losses recorded in OCI, |
• | trading securities, which are carried at fair value with unrealized gains and losses recorded in net income, |
• | a 50% equity investment acquired in a restructuring of an insured CDS carried at its proportionate share of the underlying entity's U.S. GAAP equity value. |
218
Cash consists of cash on hand and demand deposits. As a result of the lag in reporting FG VIEs, cash and short-term investments do not reflect cash outflow to the holders of the debt issued by the FG VIEs for claim payments made by the Company's insurance subsidiaries to the consolidated FG VIEs until the subsequent reporting period.
Assessment for Other-Than Temporary Impairments
The amount of other-than-temporary-impairment recognized in earnings depends on whether (1) an entity intends to sell the security or (2) it is more-likely-than-not that the entity will be required to sell the security before recovery of its amortized cost basis.
If an entity does not intend to sell the security and it is not more-likely-than-not that the Company will be required to sell the security before recovery of its amortized cost basis, the other-than-temporary-impairment is separated into (1) the amount representing the credit loss and (2) the amount related to all other factors.
The Company has a formal review process to determine other-than-temporary-impairment for securities in its investment portfolio where there is no intent to sell and it is not more-likely-than-not that it will be required to sell the security before recovery. Factors considered when assessing impairment include:
• | a decline in the market value of a security by 20% or more below amortized cost for a continuous period of at least six months; |
• | a decline in the market value of a security for a continuous period of 12 months; |
• | recent credit downgrades of the applicable security or the issuer by rating agencies; |
• | the financial condition of the applicable issuer; |
• | whether loss of investment principal is anticipated; |
• | the impact of foreign exchange rates; and |
• | whether scheduled interest payments are past due. |
The Company assesses the ability to recover the amortized cost by comparing the net present value of projected future cash flows with the amortized cost of the security. If the security is impaired and the net present value is less than the amortized cost of the investment, an other-than-temporary impairment is recorded. The net present value is calculated by discounting the Company's estimate of projected future cash flows at the effective interest rate implicit in the debt security at the time of purchase. The Company's estimates of projected future cash flows are driven by assumptions regarding probability of default and estimates regarding timing and amount of recoveries associated with a default. The Company develops these estimates using information based on historical experience, credit analysis and market observable data, such as industry analyst reports and forecasts, sector credit ratings and other relevant data. For mortgage‑backed and asset backed securities, cash flow estimates also include prepayment and other assumptions regarding the underlying collateral including default rates, recoveries and changes in value. The assumptions used in these projections requires the use of significant management judgment.
The Company's assessment of a decline in value included management's current assessment of the factors noted above. The Company also seeks advice from its outside investment managers. If that assessment changes in the future, the Company may ultimately record a loss after having originally concluded that the decline in value was temporary.
Net Investment Income and Realized Gains (Losses)
Net investment income is a function of the yield that the Company earns on invested assets and the size of the portfolio. The investment yield is a function of market interest rates at the time of investment as well as the type, credit quality and maturity of the invested assets. Accrued investment income was $98 million and $93 million as of December 31, 2014 and December 31, 2013, respectively.
219
Net Investment Income
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Income from fixed-maturity securities managed by third parties | $ | 324 | $ | 322 | $ | 346 | |||||
Income from internally managed securities: | |||||||||||
Fixed maturities | 74 | 74 | 60 | ||||||||
Other invested assets | 13 | 5 | 6 | ||||||||
Other | 1 | 0 | 1 | ||||||||
Gross investment income | 412 | 401 | 413 | ||||||||
Investment expenses | (9 | ) | (8 | ) | (9 | ) | |||||
Net investment income | $ | 403 | $ | 393 | $ | 404 | |||||
Net Realized Investment Gains (Losses)
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Gross realized gains on available-for-sale securities | $ | 14 | $ | 73 | $ | 29 | |||||
Gross realized gains on other assets in investment portfolio | 8 | 40 | 14 | ||||||||
Gross realized losses on available-for-sale securities | (5 | ) | (12 | ) | (23 | ) | |||||
Gross realized losses on other assets in investment portfolio | (2 | ) | (7 | ) | (2 | ) | |||||
Other-than-temporary impairment | (75 | ) | (42 | ) | (17 | ) | |||||
Net realized investment gains (losses) | $ | (60 | ) | $ | 52 | $ | 1 | ||||
The following table presents the roll-forward of the credit losses of fixed-maturity securities for which the Company has recognized an other-than-temporary-impairment and where the portion of the fair value adjustment related to other factors was recognized in OCI.
Roll Forward of Credit Losses
in the Investment Portfolio
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Balance, beginning of period | $ | 80 | $ | 64 | $ | 47 | |||||
Additions for credit losses on securities for which an other-than-temporary-impairment was not previously recognized | 64 | 18 | 14 | ||||||||
Eliminations of securities issued by FG VIEs | (15 | ) | — | — | |||||||
Reductions for securities sold during the period | (12 | ) | (21 | ) | — | ||||||
Additions for credit losses on securities for which an other-than-temporary-impairment was previously recognized | 7 | 19 | 3 | ||||||||
Balance, end of period | $ | 124 | $ | 80 | $ | 64 | |||||
220
Investment Portfolio
Fixed-Maturity Securities and Short-Term Investments
by Security Type
As of December 31, 2014
Investment Category | Percent of Total(1) | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Estimated Fair Value | AOCI(2) Gain (Loss) on Securities with Other-Than-Temporary Impairment | Weighted Average Credit Quality (3) | ||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||
Fixed-maturity securities: | |||||||||||||||||||||||||
Obligations of state and political subdivisions | 50 | % | $ | 5,416 | $ | 380 | $ | (1 | ) | $ | 5,795 | $ | 7 | AA | |||||||||||
U.S. government and agencies | 6 | 635 | 31 | (1 | ) | 665 | — | AA+ | |||||||||||||||||
Corporate securities | 12 | 1,320 | 53 | (5 | ) | 1,368 | (2 | ) | A | ||||||||||||||||
Mortgage-backed securities(4): | — | ||||||||||||||||||||||||
RMBS | 12 | 1,255 | 51 | (21 | ) | 1,285 | 0 | A- | |||||||||||||||||
CMBS | 6 | 639 | 20 | 0 | 659 | — | AAA | ||||||||||||||||||
Asset-backed securities | 4 | 411 | 9 | (3 | ) | 417 | 3 | BBB- | |||||||||||||||||
Foreign government securities | 3 | 296 | 8 | (2 | ) | 302 | — | AA+ | |||||||||||||||||
Total fixed-maturity securities | 93 | 9,972 | 552 | (33 | ) | 10,491 | 8 | AA- | |||||||||||||||||
Short-term investments | 7 | 767 | 0 | 0 | 767 | 0 | AA+ | ||||||||||||||||||
Total investment portfolio | 100 | % | $ | 10,739 | $ | 552 | $ | (33 | ) | $ | 11,258 | $ | 8 | AA- | |||||||||||
221
Fixed-Maturity Securities and Short-Term Investments
by Security Type
As of December 31, 2013
Investment Category | Percent of Total(1) | Amortized Cost | Gross Unrealized Gains | Gross Unrealized Losses | Estimated Fair Value | AOCI Gain (Loss) on Securities with Other-Than-Temporary Impairment | Weighted Average Credit Quality (3) | ||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||||
Fixed-maturity securities: | |||||||||||||||||||||||||
Obligations of state and political subdivisions | 47 | % | $ | 4,899 | $ | 219 | $ | (39 | ) | $ | 5,079 | $ | 4 | AA | |||||||||||
U.S. government and agencies | 6 | 674 | 32 | (6 | ) | 700 | — | AA+ | |||||||||||||||||
Corporate securities | 13 | 1,314 | 44 | (18 | ) | 1,340 | 0 | A | |||||||||||||||||
Mortgage-backed securities(4): | |||||||||||||||||||||||||
RMBS | 11 | 1,160 | 34 | (72 | ) | 1,122 | (43 | ) | A | ||||||||||||||||
CMBS | 5 | 536 | 17 | (4 | ) | 549 | — | AAA | |||||||||||||||||
Asset-backed securities | 6 | 605 | 10 | (7 | ) | 608 | 2 | BBB+ | |||||||||||||||||
Foreign government securities | 3 | 300 | 14 | (1 | ) | 313 | — | AA+ | |||||||||||||||||
Total fixed-maturity securities | 91 | 9,488 | 370 | (147 | ) | 9,711 | (37 | ) | AA- | ||||||||||||||||
Short-term investments | 9 | 904 | 0 | 0 | 904 | — | AAA | ||||||||||||||||||
Total investment portfolio | 100 | % | $ | 10,392 | $ | 370 | $ | (147 | ) | $ | 10,615 | $ | (37 | ) | AA- | ||||||||||
____________________
(1) | Based on amortized cost. |
(2) | Accumulated OCI. See also Note 21, Other Comprehensive Income. |
(3) | Ratings in the tables above represent the lower of the Moody’s and S&P classifications except for bonds purchased for loss mitigation or risk management strategies, which use internal ratings classifications. The Company’s portfolio consists primarily of high-quality, liquid instruments. |
(4) | Government-agency obligations were approximately 44% of mortgage backed securities as of December 31, 2014 and 50% as of December 31, 2013 based on fair value. |
The Company’s investment portfolio in tax-exempt and taxable municipal securities includes issuances by a wide number of municipal authorities across the U.S. and its territories. Securities rated lower than A-/A3 by S&P or Moody’s are not eligible to be purchased for the Company’s portfolio unless acquired for loss mitigation or risk management strategies.
The following tables present the fair value of the Company’s available-for-sale portfolio of obligations of state and political subdivisions as of December 31, 2014 and December 31, 2013 by state.
222
Fair Value of Available-for-Sale Portfolio of
Obligations of State and Political Subdivisions
As of December 31, 2014 (1)
State | State General Obligation | Local General Obligation | Revenue Bonds | Fair Value | Amortized Cost | Average Credit Rating | ||||||||||||||||
(in millions) | ||||||||||||||||||||||
Texas | $ | 60 | $ | 293 | $ | 305 | $ | 658 | $ | 613 | AA | |||||||||||
New York | 13 | 41 | 551 | 605 | 571 | AA | ||||||||||||||||
California | 45 | 70 | 377 | 492 | 449 | A+ | ||||||||||||||||
Florida | 47 | 34 | 256 | 337 | 311 | AA- | ||||||||||||||||
Illinois | 20 | 99 | 177 | 296 | 275 | A+ | ||||||||||||||||
Washington | 67 | 48 | 163 | 278 | 262 | AA | ||||||||||||||||
Massachusetts | 46 | 8 | 169 | 223 | 204 | AA | ||||||||||||||||
Arizona | — | 7 | 170 | 177 | 165 | AA | ||||||||||||||||
Michigan | — | — | 132 | 132 | 122 | AA- | ||||||||||||||||
Ohio | 6 | 40 | 82 | 128 | 119 | AA | ||||||||||||||||
All others | 276 | 251 | 1,096 | 1,623 | 1,528 | AA- | ||||||||||||||||
Total | $ | 580 | $ | 891 | $ | 3,478 | $ | 4,949 | $ | 4,619 | ||||||||||||
Fair Value of Available-for-Sale Portfolio of
Obligations of State and Political Subdivisions
As of December 31, 2013 (1)
State | State General Obligation | Local General Obligation | Revenue Bonds | Fair Value | Amortized Cost | Average Credit Rating | ||||||||||||||||
(in millions) | ||||||||||||||||||||||
Texas | $ | 77 | $ | 299 | $ | 277 | $ | 653 | $ | 629 | AA | |||||||||||
New York | 12 | 58 | 519 | 589 | 575 | AA | ||||||||||||||||
California | 32 | 86 | 354 | 472 | 452 | A+ | ||||||||||||||||
Florida | 33 | 59 | 242 | 334 | 318 | AA- | ||||||||||||||||
Illinois | 14 | 70 | 156 | 240 | 234 | A+ | ||||||||||||||||
Massachusetts | 44 | 16 | 147 | 207 | 200 | AA | ||||||||||||||||
Washington | 31 | 19 | 153 | 203 | 199 | AA | ||||||||||||||||
Arizona | — | 7 | 166 | 173 | 170 | AA | ||||||||||||||||
Michigan | — | 28 | 102 | 130 | 125 | AA- | ||||||||||||||||
Georgia | 13 | 18 | 97 | 128 | 128 | A+ | ||||||||||||||||
All others | 254 | 228 | 943 | 1,425 | 1,381 | AA- | ||||||||||||||||
Total | $ | 510 | $ | 888 | $ | 3,156 | $ | 4,554 | $ | 4,411 | AA- | |||||||||||
____________________
(1) | Excludes $846 million and $525 million as of December 31, 2014 and 2013, respectively, of pre-refunded bonds, at fair value. The credit ratings are based on the underlying ratings and do not include any benefit from bond insurance. |
The revenue bond portfolio is comprised primarily of essential service revenue bonds issued by transportation authorities and other utilities, water and sewer authorities, universities and healthcare providers.
223
Revenue Bonds
Sources of Funds
As of December 31, 2014 | As of December 31, 2013 | |||||||||||||||
Type | Fair Value | Amortized Cost | Fair Value | Amortized Cost | ||||||||||||
(in millions) | ||||||||||||||||
Transportation | $ | 796 | $ | 733 | $ | 642 | $ | 615 | ||||||||
Water and sewer | 563 | 527 | 459 | 453 | ||||||||||||
Tax backed | 551 | 514 | 708 | 686 | ||||||||||||
Higher education | 527 | 492 | 358 | 353 | ||||||||||||
Municipal utilities | 512 | 479 | 500 | 482 | ||||||||||||
Healthcare | 346 | 317 | 289 | 281 | ||||||||||||
All others | 183 | 173 | 200 | 192 | ||||||||||||
Total | $ | 3,478 | $ | 3,235 | $ | 3,156 | $ | 3,062 | ||||||||
The majority of the investment portfolio is managed by four outside managers. The Company has established detailed guidelines regarding credit quality, exposure to a particular sector and exposure to a particular obligor within a sector.
The following tables summarize, for all securities in an unrealized loss position, the aggregate fair value and gross unrealized loss by length of time the amounts have continuously been in an unrealized loss position.
Fixed-Maturity Securities
Gross Unrealized Loss by Length of Time
As of December 31, 2014
Less than 12 months | 12 months or more | Total | |||||||||||||||||||||
Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | ||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||
Obligations of state and political subdivisions | $ | 64 | $ | 0 | $ | 25 | $ | (1 | ) | $ | 89 | $ | (1 | ) | |||||||||
U.S. government and agencies | 139 | 0 | 68 | (1 | ) | 207 | (1 | ) | |||||||||||||||
Corporate securities | 189 | (3 | ) | 104 | (2 | ) | 293 | (5 | ) | ||||||||||||||
Mortgage-backed securities: | |||||||||||||||||||||||
RMBS | 205 | (3 | ) | 159 | (18 | ) | 364 | (21 | ) | ||||||||||||||
CMBS | 36 | 0 | 19 | 0 | 55 | 0 | |||||||||||||||||
Asset-backed securities | 56 | (2 | ) | 18 | (1 | ) | 74 | (3 | ) | ||||||||||||||
Foreign government securities | 108 | (2 | ) | 0 | 0 | 108 | (2 | ) | |||||||||||||||
Total | $ | 797 | $ | (10 | ) | $ | 393 | $ | (23 | ) | $ | 1,190 | $ | (33 | ) | ||||||||
Number of securities(1) | 125 | 82 | 198 | ||||||||||||||||||||
Number of securities with other-than-temporary impairment | 3 | 7 | 10 | ||||||||||||||||||||
224
Fixed-Maturity Securities
Gross Unrealized Loss by Length of Time
As of December 31, 2013
Less than 12 months | 12 months or more | Total | |||||||||||||||||||||
Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | ||||||||||||||||||
(dollars in millions) | |||||||||||||||||||||||
Obligations of state and political subdivisions | $ | 781 | $ | (39 | ) | $ | 5 | $ | 0 | $ | 786 | $ | (39 | ) | |||||||||
U.S. government and agencies | 173 | (6 | ) | — | — | 173 | (6 | ) | |||||||||||||||
Corporate securities | 401 | (18 | ) | 3 | 0 | 404 | (18 | ) | |||||||||||||||
Mortgage-backed securities: | |||||||||||||||||||||||
RMBS | 414 | (21 | ) | 186 | (51 | ) | 600 | (72 | ) | ||||||||||||||
CMBS | 121 | (4 | ) | — | — | 121 | (4 | ) | |||||||||||||||
Asset-backed securities | 196 | (2 | ) | 42 | (5 | ) | 238 | (7 | ) | ||||||||||||||
Foreign government securities | 54 | (1 | ) | 1 | 0 | 55 | (1 | ) | |||||||||||||||
Total | $ | 2,140 | $ | (91 | ) | $ | 237 | $ | (56 | ) | $ | 2,377 | $ | (147 | ) | ||||||||
Number of securities | 425 | 33 | 458 | ||||||||||||||||||||
Number of securities with other-than-temporary impairment | 13 | 11 | 24 | ||||||||||||||||||||
___________________
(1) | The number of securities does not add across because of lots of the same securities that have been purchased at different times and appear in both categories above (i.e., Less than 12 months and 12 months or more). If a security appears in both categories, it is counted only once in the Total column. |
Of the securities in an unrealized loss position for 12 months or more as of December 31, 2014, three securities had unrealized losses greater than 10% of book value. The total unrealized loss for these securities as of December 31, 2014 was $15 million. The Company has determined that the unrealized losses recorded as of December 31, 2014 are yield related and not the result of other-than-temporary-impairment.
The amortized cost and estimated fair value of available-for-sale fixed-maturity securities by contractual maturity as of December 31, 2014 are shown 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.
Distribution of Fixed-Maturity Securities
by Contractual Maturity
As of December 31, 2014
Amortized Cost | Estimated Fair Value | ||||||
(in millions) | |||||||
Due within one year | $ | 111 | $ | 112 | |||
Due after one year through five years | 1,961 | 2,028 | |||||
Due after five years through 10 years | 2,286 | 2,422 | |||||
Due after 10 years | 3,720 | 3,985 | |||||
Mortgage-backed securities: | |||||||
RMBS | 1,255 | 1,285 | |||||
CMBS | 639 | 659 | |||||
Total | $ | 9,972 | $ | 10,491 | |||
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The investment portfolio contains securities that are either held in trust for the benefit of reinsurers in accordance with statutory requirements, placed on deposit to fulfill state licensing requirements, or otherwise restricted in the amount of $268 million and $396 million as of December 31, 2014 and December 31, 2013, respectively, based on fair value.
The fair value of the Company’s pledged securities to secure its obligations under its CDS exposure totaled $376 million and $677 million as of December 31, 2014 and December 31, 2013, respectively.
No material investments of the Company were non-income producing for years ended December 31, 2014 and 2013, respectively.
Internally Managed Portfolio
The investment portfolio tables shown above include both assets managed externally and internally. In the table below, more detailed information is provided for the component of the total investment portfolio that is internally managed (excluding short-term investments). The internally managed portfolio, as defined below, represents approximately 8% and 9% of the investment portfolio, on a fair value basis as of December 31, 2014 and December 31, 2013, respectively. The internally managed portfolio consists primarily of the Company's investments in securities for (i) loss mitigation purposes, (ii) other risk management purposes and (iii) where the Company believes a particular security presents an attractive investment opportunity.
One of the Company's strategies for mitigating losses has been to purchase securities it has insured that have expected losses, at discounted prices (assets purchased for loss mitigation purposes). In addition, the Company holds other invested assets that were obtained or purchased as part of negotiated settlements with insured counterparties or under the terms of our financial guaranties (other risk management assets).
Additional detail about the types and amounts of securities acquired by the Company for loss mitigation, other risk management and in the trading portfolio is set forth in the table below.
Internally Managed Portfolio
Carrying Value
As of December 31, | |||||||
2014 | 2013 | ||||||
(in millions) | |||||||
Assets purchased for loss mitigation and other risk management purposes: | |||||||
Fixed maturity securities | $ | 835 | $ | 761 | |||
Other invested assets | 46 | 82 | |||||
Other | 79 | 88 | |||||
Total | $ | 960 | $ | 931 | |||
12. | Insurance Company Regulatory Requirements |
Each of the Company's insurance companies' ability to pay dividends depends, among other things, upon their financial condition, results of operations, cash requirements, compliance with rating agency requirements, and is also subject to restrictions contained in the insurance laws and related regulations of their state of domicile and other states. Financial statements prepared in accordance with accounting practices prescribed or permitted by local insurance regulatory authorities differ in certain respects from GAAP.
The Company's U.S. domiciled insurance companies prepare statutory financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners (“NAIC”) and their respective insurance departments. Prescribed statutory accounting practices are set forth in the NAIC Accounting Practices and Procedures Manual. The Company has no permitted accounting practices on a statutory basis.
GAAP differs in certain significant respects from U.S. insurance companies' statutory accounting practices prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices:
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• | upfront premiums are earned when related principal and interest have expired rather than earned over the expected period of coverage; |
• | acquisition costs are charged to expense as incurred rather than over the period that related premiums are earned; |
• | a contingency reserve is computed based on statutory requirements, but no such reserve is required under GAAP; |
• | certain assets designated as “non-admitted assets” are charged directly to statutory surplus, but are reflected as assets under GAAP; |
• | investments in subsidiaries are carried on the balance sheet on the equity basis, to the extent admissible, rather than consolidated with the parent; |
• | the amount of deferred tax assets that may be admitted is subject to an adjusted surplus threshold and is generally limited to the lesser of those assets the Company expects to realize within three years of the balance sheet date or fifteen percent of the Company's adjusted surplus. This realization period and surplus percentage is subject to change based on the amount of adjusted surplus. Under GAAP there is no non-admitted asset determination, rather a valuation allowance is recorded to reduce the deferred tax asset to an amount that is more likely than not to be realized; |
• | insured credit derivatives are accounted for as insurance contracts rather than as derivative contracts measured at fair value; |
• | bonds are generally carried at amortized cost rather than fair value; |
• | VIEs and refinancing vehicles are not consolidated; |
• | surplus notes are recognized as surplus and each payment of principal and interest is recorded only upon approval of the insurance regulator rather than liabilities with periodic accrual of interest; |
• | push-down acquisition accounting is not applicable under statutory accounting practices, as it is under GAAP; |
• | expected losses are discounted at a rate of 4.5% or 5.0%, recorded when the loss is deemed probable and without consideration of the deferred premium revenue rather than discounted at the risk free rate at the end of each reporting period and only to the extent they exceed deferred premium revenue; |
• | the present value of installment premiums and commissions are not recorded on the balance sheet as they are under GAAP. |
AG Re, a Bermuda regulated Class 3B insurer, prepares its statutory financial statements in conformity with the accounting principles set forth in the Insurance Act 1978, amendments thereto and related regulations. GAAP differs in certain significant respects from statutory accounting practices prescribed or permitted by Bermuda insurance regulatory authorities. The principal differences result from the following statutory accounting practices:
• | acquisition costs on upfront premiums are charged to operations as incurred, rather than over the period that related premiums are earned; |
• | certain assets designated as “non-admitted assets” are charged directly to statutory surplus rather than reflected as assets under GAAP; |
• | insured credit derivatives are accounted for as insurance contracts (except that loss reserves on insured credit derivatives are not net of unearned premium reserve), rather than as derivative contracts measured at fair value; |
• | Loss reserves on non derivative contracts are net of unearned premium, which is offset by deferred acquisition costs, rather than only unearned premium. Loss reserves include a statutory reserve which includes a discount safety margin and statutory catastrophe reserve. |
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Insurance Regulatory Amounts Reported
Policyholders' Surplus | Net Income (Loss) | ||||||||||||||||||
As of December 31, | Year Ended December 31, | ||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2012 | |||||||||||||||
(in millions) | |||||||||||||||||||
U.S. statutory companies: | |||||||||||||||||||
AGM(1) | $ | 2,267 | $ | 1,733 | $ | 304 | $ | 340 | $ | 203 | |||||||||
MAC | $ | 612 | $ | 514 | $ | 75 | $ | 26 | $ | 1 | |||||||||
AGC(1) | 1,086 | 693 | 116 | 211 | 31 | ||||||||||||||
Bermuda statutory company: | |||||||||||||||||||
AG Re | 1,114 | 1,119 | 28 | 103 | 117 | ||||||||||||||
____________________
(1) | Policyholders' surplus of AGM and AGC include their indirect share of MAC. AGM and AGC own approximately 61% and 39%, respectively, of the outstanding stock of Municipal Assurance Holdings Inc. ("MAC Holdings"), which owns 100% of the outstanding common stock of MAC. |
On July 16, 2013, the Company completed a series of transactions that increased the capitalization of MAC to $800 million on a statutory basis. The Company does not currently anticipate that MAC will distribute any dividends.
AGM and its subsidiaries Assured Guaranty Municipal Insurance Company ("AGMIC") and Assured Guaranty (Bermuda) Ltd. ("AGBM") terminated the reinsurance pooling agreement pursuant to which AGMIC and AGBM had assumed a quota share percentage of the financial guaranty insurance policies issued by AGM, and AGM reassumed such ceded business. Subsequently, AGMIC was merged into AGM, with AGM as the surviving company.
AGBM, which had made a loan of $82.5 million to AGUS, an indirect parent holding company of AGM, received all of the outstanding shares of MAC held by AGUS and cash, in full satisfaction of the principal of and interest on such loan. After AGBM distributed substantially all of its assets, including the MAC shares, to AGM as a dividend, AGM sold AGBM to its affiliate AG Re. Subsequently, AGBM and AG Re merged, with AG Re as the surviving company. The sale of AGBM to, and subsequent merger with, AG Re were each effective as of July 17, 2013.
MAC Holdings, was formed to own 100% of the outstanding stock of MAC. AGM and its affiliate AGC subscribed for approximately 61% and 39% of the outstanding MAC Holdings common stock, respectively, for which AGM paid $425 million and AGC paid $275 million, as consideration. The consideration consisted of all of MAC's outstanding common stock (in the case of AGM), cash and marketable securities.
MAC Holdings then contributed cash and marketable securities having a fair market value sufficient to increase MAC's policyholders' surplus to approximately $400 million, and purchased a surplus note issued by MAC in the principal amount of $300 million. In addition, AGM purchased a surplus note issued by MAC in the principal amount of $100 million.
Following the increase in MAC's capitalization, AGM ceded par exposure of approximately $87 billion and unearned premiums of approximately $468 million to MAC, and AGC ceded par exposure of approximately $24 billion and unearned premiums of approximately $249 million to MAC.
In addition, on July 15, 2013, AGM and its wholly-owned subsidiary, AGE (together, the "AGM Group") were notified that the New York State Department of Financial Services ("NYDFS") does not object to the AGM Group reassuming contingency reserves that they had ceded to AG Re and electing to cease ceding future contingency reserves to AG Re under the following circumstances:
• | The AGM Group may reassume 33% of a contingency reserve base of approximately $250 million (the “NY Contingency Reserve Base”) in 2013, after July 16, 2013, the date on which the transactions for the capitalization of MAC were completed (the “Closing Date”). |
• | The AGM Group may reassume 50% of the NY Contingency Reserve Base in 2014, no earlier than the one year anniversary of the Closing Date, with the prior approval of the NYDFS. |
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• | The AGM Group may reassume the remaining 17% of the NY Contingency Reserve Base in 2015, no earlier than the two year anniversary of the Closing Date, with the prior approval of the NYDFS. |
At the same time, AGC was notified that the Maryland Insurance Administration ("MIA") does not object to AGC reassuming contingency reserves that it had ceded to AG Re and electing to cease ceding future contingency reserves to AG Re under the following circumstances:
• | AGC may reassume 33% of a contingency reserve base of approximately $267 million (the “MD Contingency Reserve Base”) in 2013, after the Closing Date. |
• | AGC may reassume 50% of the MD Contingency Reserve Base in 2014, no earlier than the one year anniversary of the Closing Date, with the prior approval of the MIA and the NYDFS. |
• | AGC may reassume the remaining 17% of the MD Contingency Reserve Base in 2015, no earlier than the two year anniversary of the Closing Date, with the prior approval of the MIA and the NYDFS. |
The reassumption of the contingency reserves has the effect of increasing contingency reserves by the amount reassumed and decreasing policyholders' surplus by the same amount; there would be no impact on the statutory or rating agency capital as a result of the reassumption. The reassumption of contingency reserves would permit the release of amounts from the AG Re trust accounts securing AG Re's reinsurance of the AGM Group and AGC.
In the third quarter of 2013, AGM and AGC reassumed 33% of their respective contingency reserve bases, which permitted the release of approximately $130 million of assets from the AG Re trust accounts securing AG Re's reinsurance of AGM and AGC, after adjusting for increases in the amounts required to be held in such accounts due to changes in asset values.
In the third quarter of 2014, AGM and AGC reassumed 50% of their respective contingency reserve bases (approximately $244 million in the aggregate). In addition, in the fourth quarter of 2014, AGE reassumed 83% (representing the first and second installments of the approved reassumption) of its portion of the NY Contingency Reserve Base (approximately $24.5 million in the aggregate). These 2014 reassumptions collectively permitted the release of approximately $274 million of assets from the AG Re trust accounts securing AG Re's reinsurance of the AGM Group and AGC, after taking into account other, normal-course adjustments to AG Re’s collateral requirements such as changes in asset values and changes in assumed reserves.
From time to time, AGM and AGC have obtained approval from their regulators to release contingency reserves based on losses or because the accumulated reserve is deemed excessive in relation to the insurer's outstanding insured obligations. In 2014, on the latter basis, AGM obtained NYDFS approval for a contingency reserve release of approximately $588 million and AGC obtained MIA approval for a contingency reserve release of approximately $540 million.
Dividend Restrictions and Capital Requirements
Under New York insurance law, AGM may only pay dividends out of "earned surplus", which is the portion of a company's surplus that represents the net earnings, gains or profits (after deduction of all losses) that have not been distributed to shareholders as dividends or transferred to stated capital or capital surplus, or applied to other purposes permitted by law, but does not include unrealized appreciation of assets. AGM may pay dividends without the prior approval of the New York Superintendent of Financial Services ("New York Superintendent") that, together with all dividends declared or distributed by it during the preceding 12 months, does not exceed the lesser of 10% of its policyholders' surplus (as of the last annual or quarterly statement filed with the New York Superintendent) or 100% of its adjusted net investment income during that period. The maximum amount available during 2015 for AGM to distribute as dividends without regulatory approval, after giving effect to dividends paid in the prior 12 months, is estimated to be approximately $227 million, of which approximately $67 million is available for distribution in the first quarter of 2015.
Under Maryland's insurance law, AGC may, with prior notice to the Maryland Insurance Commissioner, pay an ordinary dividend that, together with all dividends paid in the prior 12 months, does not exceed 10% of its policyholders' surplus (as of the prior December 31) or 100% of its adjusted net investment income during that period. The maximum amount available during 2015 for AGC to distribute as ordinary dividends will be approximately $90 million, of which approximately $21 million is available for distribution in the first quarter of 2015, after giving effect to dividends paid in the prior 12 months.
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MAC is subject to the same dividend limitations described above for AGM. The Company does not currently anticipate that MAC will distribute any dividends.
Any distribution (including repurchase of shares) of any share capital, contributed surplus or other statutory capital) that would reduce AG Re's total statutory capital by 15% or more of its total statutory capital as set out in its previous year's financial statements requires the prior approval of the Authority. Separately, dividends are paid out of an insurer's statutory surplus and cannot exceed that surplus. Further, annual dividends cannot exceed 25% of total statutory capital and surplus, which is $279 million, without AG Re certifying to the Bermuda Monetary Authority that it will continue to meet required margins. Based on the foregoing limitations, in 2015 AG Re has the capacity to (i) make capital distributions in an aggregate amount up to $127 million without the prior approval of the Authority and (ii) declare and pay dividends in an aggregate amount up to the limit of its outstanding statutory surplus, which is $271 million. Such dividend capacity is further limited by the actual amount of AG Re’s unencumbered assets, which amount changes from time to time due in part to collateral posting requirements. As of December 31, 2014, AG Re had unencumbered assets of approximately $651 million.
U.K. company law prohibits each of AGE and AGUK from declaring a dividend to its shareholders unless it has “profits available for distribution.” The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the U.K. insurance regulatory laws impose no statutory restrictions on a general insurer's ability to declare a dividend, the Prudential Regulation Authority's capital requirements may in practice act as a restriction on dividends. The Company does not expect AGE or AGUK to distribute any dividends at this time
Dividends and Surplus Notes
By Insurance Company Subsidiaries
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Dividends paid by AGC to AGUS | $ | 69 | $ | 67 | $ | 55 | |||||
Dividends paid by AGM to AGMH | 160 | 163 | 30 | ||||||||
Dividends paid by AG Re to AGL | 82 | 144 | 151 | ||||||||
Repayment of surplus note by AGM to AGMH | 50 | 50 | 50 | ||||||||
Issuance of surplus notes by MAC to MAC Holdings | — | (300 | ) | — | |||||||
Issuance of surplus notes by MAC to AGM | — | (100 | ) | — | |||||||
13. | Income Taxes |
Accounting Policy
The provision for income taxes consists of an amount for taxes currently payable and an amount for deferred taxes. Deferred income taxes are provided for temporary differences between the financial statement carrying amounts and tax bases of assets and liabilities, using enacted rates in effect for the year in which the differences are expected to reverse. A valuation allowance is recorded to reduce the deferred tax asset to an amount that is more likely than not to be realized.
Non-interest‑bearing tax and loss bonds are purchased in the amount of the tax benefit that results from deducting contingency reserves as provided under Internal Revenue Code Section 832(e). The Company records the purchase of tax and loss bonds in deferred taxes.
The Company recognizes tax benefits only if a tax position is “more likely than not” to prevail.
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Overview
AGL, and its "Bermuda Subsidiaries," which consist of AG Re, AGRO, and Cedar Personnel Ltd., are not subject to any income, withholding or capital gains taxes under current Bermuda law. The Company has received an assurance from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, AGL and its Bermuda Subsidiaries will be exempt from taxation in Bermuda until March 31, 2035. AGL's U.S. and U.K. subsidiaries are subject to income taxes imposed by U.S. and U.K. authorities, respectively, and file applicable tax returns. In addition, AGRO, a Bermuda domiciled company and AGE, a U.K. domiciled company, have elected under Section 953(d) of the U.S. Internal Revenue Code to be taxed as a U.S. domestic corporation.
In November 2013, AGL became tax resident in the U.K. although it will remain a Bermuda-based company and its administrative and head office functions will continue to be carried on in Bermuda. As a company that is not incorporated in the U.K., AGL currently intends to manage the affairs of AGL in such a way as to establish and maintain its status as a company that is tax resident in the U.K. As a U.K. tax resident company, AGL is required to file a corporation tax return with Her Majesty’s Revenue & Customs (“HMRC”). AGL is subject to U.K. corporation tax in respect of its worldwide profits (both income and capital gains), subject to any applicable exemptions. The main rate of corporation tax is 21% currently; such rate fell to 21% as of April 1, 2014 and will fall to 20% as of April 1, 2015. AGL has also registered in the U.K. to report its Value Added Tax (“VAT”) liability. The current rate of VAT is 20%. Assured Guaranty does not expect that becoming U.K. tax resident will result in any material change in the group’s overall tax charge. Assured Guaranty expects that the dividends AGL receives from its direct subsidiaries will be exempt from U.K. corporation tax due to the exemption in section 931D of the U.K. Corporation Tax Act 2009. In addition, any dividends paid by AGL to its shareholders should not be subject to any withholding tax in the U.K. The U.K. government implemented a new tax regime for “controlled foreign companies” (“CFC regime”) effective January 1, 2013. Assured Guaranty does not expect any profits of non-U.K. resident members of the group to be taxed under the CFC regime and has obtained a clearance from HMRC confirming this on the basis of current facts.
For the periods beginning on July 1, 2009 and forward, AGMH files a consolidated federal income tax return with AGUS, AGC, AG Financial Products Inc. ("AGFP") and AG Analytics Inc. (“AGUS consolidated tax group”). Beginning on May 12, 2012, MAC also joined the AGUS consolidated tax group. Assured Guaranty Overseas US Holdings Inc. and its subsidiaries AGRO and AG Intermediary Inc., file their own consolidated federal income tax return.
Provision for Income Taxes
The effective tax rates reflect the proportion of income recognized by each of the Company’s operating subsidiaries, with U.S. subsidiaries taxed at the U.S. marginal corporate income tax rate of 35%, U.K. subsidiaries taxed at the U.K. blended marginal corporate tax rate of 21.5% unless subject to U.S. tax by election or as a U.S. controlled foreign corporation, and no taxes for the Company’s Bermuda subsidiaries unless subject to U.S. tax by election or as a U.S. controlled foreign corporation. For periods subsequent to April 1, 2014, the U.K. corporation tax rate has been reduced to 21%, for the period April 1, 2013 to April 1, 2014 the U.K. corporation tax rate was 23% resulting in a blended tax rate of 21.5% in 2014, and prior to April 1, 2013, the U.K. corporation tax rate was 24% resulting in a blended tax rate of 23.25% in 2013. The Company’s overall effective tax rate fluctuates based on the distribution of income across jurisdictions.
A reconciliation of the difference between the provision for income taxes and the expected tax provision at statutory rates in taxable jurisdictions is presented below.
Effective Tax Rate Reconciliation
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Expected tax provision (benefit) at statutory rates in taxable jurisdictions | $ | 490 | $ | 390 | $ | 76 | |||||
Tax-exempt interest | (53 | ) | (57 | ) | (61 | ) | |||||
Change in liability for uncertain tax positions | 9 | (2 | ) | 2 | |||||||
Other | (3 | ) | 3 | 5 | |||||||
Total provision (benefit) for income taxes | $ | 443 | $ | 334 | $ | 22 | |||||
Effective tax rate | 28.9 | % | 29.2 | % | 16.5 | % | |||||
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The expected tax provision at statutory rates in taxable jurisdictions is calculated as the sum of pretax income in each jurisdiction multiplied by the statutory tax rate of the jurisdiction by which it will be taxed. Pretax income of the Company’s subsidiaries which are not U.S. or U.K. domiciled but are subject to U.S. or U.K. tax by election, establishment of tax residency or as controlled foreign corporations, are included at the U.S. or U.K. statutory tax rate. Where there is a pretax loss in one jurisdiction and pretax income in another, the total combined expected tax rate may be higher or lower than any of the individual statutory rates.
The following table presents pretax income and revenue by jurisdiction.
Pretax Income (Loss) by Tax Jurisdiction
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
United States | $ | 1,420 | $ | 1,118 | $ | 218 | |||||
Bermuda | 142 | 27 | (86 | ) | |||||||
U.K. | (31 | ) | (3 | ) | 0 | ||||||
Total | $ | 1,531 | $ | 1,142 | $ | 132 | |||||
Revenue by Tax Jurisdiction
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
United States | $ | 1,633 | $ | 1,389 | $ | 875 | |||||
Bermuda | 365 | 219 | 79 | ||||||||
U.K. | (4 | ) | 0 | 0 | |||||||
Total | $ | 1,994 | $ | 1,608 | $ | 954 | |||||
Pretax income by jurisdiction may be disproportionate to revenue by jurisdiction to the extent that insurance losses incurred are disproportionate.
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Components of Net Deferred Tax Assets
As of December 31, | |||||||
2014 | 2013 | ||||||
(in millions) | |||||||
Deferred tax assets: | |||||||
Unrealized losses on credit derivative financial instruments, net | $ | 224 | $ | 402 | |||
Unearned premium reserves, net | 63 | 63 | |||||
Loss and LAE reserve | 66 | 134 | |||||
Tax and loss bonds | 39 | 33 | |||||
Alternative minimum tax credit | 57 | 90 | |||||
Foreign tax credit | — | 37 | |||||
FG VIEs | 13 | 29 | |||||
DAC | 35 | 40 | |||||
Investment basis difference | 104 | 93 | |||||
Deferred compensation | 38 | 33 | |||||
Other | 19 | 21 | |||||
Total deferred income tax assets | 658 | 975 | |||||
Deferred tax liabilities: | |||||||
Contingency reserves | 64 | 47 | |||||
Public debt | 96 | 98 | |||||
Unrealized appreciation on investments | 159 | 68 | |||||
Unrealized gains on CCS | 22 | 16 | |||||
Market discount | 36 | 24 | |||||
Other | 21 | 34 | |||||
Total deferred income tax liabilities | 398 | 287 | |||||
Net deferred income tax asset | $ | 260 | $ | 688 | |||
As of December 31, 2014, the Company had alternative minimum tax credits of $57 million which do not expire. Management believes sufficient future taxable income exists to realize the full benefit of these tax credits.
As of December 31, 2014, AGRO had a stand-alone net operating loss ("NOL") of $6 million, compared with $13 million as of December 31, 2013, which is available through 2023 to offset its future U.S. taxable income. AGRO's stand alone NOL may not offset the income of any other members of AGRO's consolidated group with very limited exceptions and the Internal Revenue Code limits the amounts of NOL that AGRO may utilize each year.
Valuation Allowance
The Company came to the conclusion that it is more likely than not that its net deferred tax asset will be fully realized after weighing all positive and negative evidence available as required under GAAP. The positive evidence that was considered included the cumulative operating income the Company has earned over the last three years, and the significant unearned premium income to be included in taxable income. The positive evidence outweighs any negative evidence that exists. As such, the Company believes that no valuation allowance is necessary in connection with this deferred tax asset. The Company will continue to analyze the need for a valuation allowance on a quarterly basis.
Audits
AGUS has open tax years with the U.S. Internal Revenue Service (“IRS”) for 2009 forward and is currently under audit for the 2009-2012 tax years. The IRS concluded its field work with respect to tax years 2006 through 2008 without adjustment. On February 20, 2013 the IRS notified AGUS that the Joint Committee on Taxation completed its review of the 2006 through 2008 tax years and has accepted the results of the IRS examination without exception. Assured Guaranty Oversees US Holdings Inc. has open tax years of 2010 forward. The IRS concluded its field work with respect to tax year through 2009 for AGMH and subsidiaries while members of the Dexia Holdings Inc. consolidated tax group without adjustment. The Company's U.K. subsidiaries are not currently under examination and have open tax years of 2012 forward.
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Uncertain Tax Positions
The following table provides a reconciliation of the beginning and ending balances of the total liability for unrecognized tax benefits. The Company does not believe it is reasonably possible that this amount will change significantly in the next twelve months.
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Balance as of January 1, | $ | 20 | $ | 22 | $ | 20 | |||||
True-up from tax return filings | 6 | 4 | — | ||||||||
Increase in unrecognized tax benefits as a result of position taken during the current period | 2 | 3 | 2 | ||||||||
Decrease due to closing of IRS audit | — | (9 | ) | — | |||||||
Balance as of December 31, | $ | 28 | $ | 20 | $ | 22 | |||||
The Company's policy is to recognize interest and penalties related to uncertain tax positions in income tax expense and has accrued approximately $1 million per year from 2012 to 2014. As of December 31, 2014 and December 31, 2013, the Company has accrued $4.5 million and $3.5 million of interest, respectively.
The total amount of unrecognized tax benefits as of December 31, 2014, that would affect the effective tax rate, if recognized, was $28 million.
Liability For Tax Basis Step-Up Adjustment
In connection with the Company's initial public offering, the Company and ACE Financial Services Inc. (“AFS”), a subsidiary of ACE Limited, entered into a tax allocation agreement, whereby the Company and AFS made a “Section 338 (h)(10)” election that has the effect of increasing the tax basis of certain affected subsidiaries' tangible and intangible assets to fair value. Future tax benefits that the Company derives from the election will be payable to AFS when realized by the Company.
As a result of the election, the Company has adjusted its net deferred tax liability, to reflect the new tax basis of the Company's affected assets. The additional basis is expected to result in increased future income tax deductions and, accordingly, may reduce income taxes otherwise payable by the Company. Any tax benefit realized by the Company will be paid to AFS. Such tax benefits will generally be calculated by comparing the Company's affected subsidiaries' actual taxes to the taxes that would have been owed by those subsidiaries had the increase in basis not occurred. After a 15 year period which ends in 2019, to the extent there remains an unrealized tax benefit, the Company and AFS will negotiate a settlement of the unrealized benefit based on the expected realization at that time.
As of December 31, 2014 and December 31, 2013, the liability for tax basis step-up adjustment, which is included in the Company's balance sheets in “Other liabilities,” was $4 million and $5 million, respectively. The Company has paid ACE Limited and correspondingly reduced its liability by $1 million in 2014.
Tax Treatment of CDS
The Company treats the guaranty it provides on CDS as an insurance contract for tax purposes and as such a taxable loss does not occur until the Company expects to make a loss payment to the buyer of credit protection based upon the occurrence of one or more specified credit events with respect to the contractually referenced obligation or entity. The Company holds its CDS to maturity, at which time any unrealized fair value loss in excess of credit-related losses would revert to zero. The tax treatment of CDS is an unsettled area of the law. The uncertainty relates to the IRS determination of the income or potential loss associated with CDS as either subject to capital gain (loss) or ordinary income (loss) treatment. In treating CDS as insurance contracts the Company treats both the receipt of premium and payment of losses as ordinary income and believes it is more likely than not that any CDS credit related losses will be treated as ordinary by the IRS. To the extent the IRS takes the view that the losses are capital losses in the future and the Company incurred actual losses associated with the CDS, the Company would need sufficient taxable income of the same character within the carryback and carryforward period available under the tax law.
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14. | Reinsurance and Other Monoline Exposures |
The Company assumes exposure on insured obligations (“Assumed Business”) and cedes portions of its exposure on obligations it has insured (“Ceded Business”) in exchange for premiums, net of ceding commissions. The Company has historically entered into ceded reinsurance contracts in order to obtain greater business diversification and reduce the net potential loss from large risks.
Accounting Policy
For business assumed and ceded, the accounting model of the underlying direct financial guaranty contract dictates the accounting model used for the reinsurance contract (except for those eliminated as FG VIEs). For any assumed or ceded financial guaranty insurance premiums, the accounting model described in Note 4 is followed, for assumed and ceded financial guaranty insurance losses, the accounting model in Note 7 is followed. For any assumed or ceded credit derivative contracts, the accounting model in Note 9 is followed.
Assumed and Ceded Business
The Company assumes business from other monoline financial guaranty companies. Under these relationships, the Company assumes a portion of the ceding company’s insured risk in exchange for a premium. The Company may be exposed to risk in this portfolio in that the Company may be required to pay losses without a corresponding premium in circumstances where the ceding company is experiencing financial distress and is unable to pay premiums. The Company’s facultative and treaty agreements are generally subject to termination at the option of the ceding company:
• | if the Company fails to meet certain financial and regulatory criteria and to maintain a specified minimum financial strength rating, or |
• | upon certain changes of control of the Company. |
Upon termination under these conditions, the Company may be required (under some of its reinsurance agreements) to return to the ceding company unearned premiums (net of ceding commissions) and loss reserves calculated on a statutory basis of accounting, attributable to reinsurance assumed pursuant to such agreements after which the Company would be released from liability with respect to the Assumed Business.
Upon the occurrence of the conditions set forth in the first bullet above, whether or not an agreement is terminated, the Company may be required to obtain a letter of credit or alternative form of security to collateralize its obligation to perform under such agreement or it may be obligated to increase the level of ceding commission paid.
The downgrade of the financial strength ratings of AG Re or of AGC gives certain reinsurance counterparties the right to recapture ceded business, which would lead to a reduction in the Company's unearned premium reserve and related earnings on such reserve. With respect to a significant portion of the Company's in-force financial guaranty assumed business, based on AG Re's and AGC's current ratings and subject to the terms of each reinsurance agreement, the third party ceding company may have the right to recapture assumed business ceded to AG Re and/or AGC, and in connection therewith, to receive payment from the assuming reinsurer of an amount equal to the reinsurer’s statutory unearned premium (net of ceding commissions) and statutory loss reserves (if any) associated with that business, plus, in certain cases, an additional ceding commission. As of December 31, 2014, if each third party company ceding business to AG Re and/or AGC had a right to recapture such business, and chose to exercise such right, the aggregate amounts that AG Re and AGC could be required to pay to all such companies would be approximately $85 million and $45 million, respectively.
The Company has Ceded Business to non-affiliated companies to limit its exposure to risk. Under these relationships, the Company cedes a portion of its insured risk in exchange for a premium paid to the reinsurer. The Company remains primarily liable for all risks it directly underwrites and is required to pay all gross claims. It then seeks reimbursement from the reinsurer for its proportionate share of claims. The Company may be exposed to risk for this exposure if it were required to pay the gross claims and not be able to collect ceded claims from an assuming company experiencing financial distress. A number of the financial guaranty insurers to which the Company has ceded par have experienced financial distress and been downgraded by the rating agencies as a result. In addition, state insurance regulators have intervened with respect to some of these insurers. The Company’s ceded contracts generally allow the Company to recapture Ceded Business after certain triggering events, such as reinsurer downgrades.
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Over the past several years, the Company has entered into several commutations in order to reassume previously ceded books of business from its reinsurers. The Company has also canceled assumed reinsurance contracts.
Net Effect of Commutations of Ceded and
Cancellations of Assumed Reinsurance Contracts
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Increase (decrease) in net unearned premium reserve | $ | 20 | $ | 11 | $ | 109 | |||||
Increase (decrease) in net par outstanding | 1,167 | 151 | 19,173 | ||||||||
Commutation gains recorded in other income | 23 | 2 | 82 | ||||||||
The following table presents the components of premiums and losses reported in the consolidated statement of operations and the contribution of the Company's Assumed and Ceded Businesses.
Effect of Reinsurance on Statement of Operations
Year Ended December 31, | ||||||||||
2014 | 2013 | 2012 | ||||||||
(in millions) | ||||||||||
Premiums Written: | ||||||||||
Direct | $ | 116 | $ | 106 | 244 | |||||
Assumed(1) | (12 | ) | 17 | 9 | ||||||
Ceded(2) | 15 | 2 | 51 | |||||||
Net | $ | 119 | $ | 125 | 304 | |||||
Premiums Earned: | ||||||||||
Direct | $ | 581 | $ | 819 | 936 | |||||
Assumed | 47 | 40 | 50 | |||||||
Ceded | (58 | ) | (107 | ) | (133 | ) | ||||
Net | $ | 570 | $ | 752 | 853 | |||||
Loss and LAE: | ||||||||||
Direct | $ | 132 | $ | 110 | 636 | |||||
Assumed | 37 | 73 | (4 | ) | ||||||
Ceded | (43 | ) | (29 | ) | (128 | ) | ||||
Net | $ | 126 | $ | 154 | 504 | |||||
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(1) | Negative assumed premiums written were due to cancellations and changes in expected Debt Service schedules. |
(2) | Positive ceded premiums written were due to commutations and changes in expected Debt Service schedules. |
On January 24, 2012, AGC reinsured approximately $1.8 billion of U.S. public finance par from Radian Asset. In connection with the reinsurance assumption, the Company received a payment of $22 million.
Reinsurer Exposure
In addition to assumed and ceded reinsurance arrangements, the Company may also have exposure to some financial guaranty reinsurers (i.e., monolines) in other areas. Second-to-pay insured par outstanding represents transactions the Company has insured that were previously insured by other monolines. The Company underwrites such transactions based on the underlying insured obligation without regard to the primary insurer. Another area of exposure is in the investment portfolio where the Company holds fixed-maturity securities that are wrapped by monolines and whose value may decline based on the rating of the monoline. As of December 31, 2014, based on fair value, the Company had fixed-maturity securities in its investment portfolio consisting of $330 million insured by National Public Finance Guarantee Corporation, $266 million insured by Ambac Assurance Corporation ("Ambac") and $29 million insured by other guarantors.
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Exposure by Reinsurer
Ratings at | Par Outstanding (1) | |||||||||||||||
February 24, 2015 | As of December 31, 2014 | |||||||||||||||
Reinsurer | Moody’s Reinsurer Rating | S&P Reinsurer Rating | Ceded Par Outstanding | Second-to- Pay Insured Par Outstanding | Assumed Par Outstanding | |||||||||||
(dollars in millions) | ||||||||||||||||
American Overseas Reinsurance Company Limited (f/k/a Ram Re) | WR (2) | WR | $ | 6,727 | $ | — | $ | 30 | ||||||||
Tokio Marine & Nichido Fire Insurance Co., Ltd. (“Tokio”) | Aa3 (3) | AA- (3) | 5,276 | — | — | |||||||||||
Radian Asset | Ba1 | B+ | 4,104 | 21 | 671 | |||||||||||
Syncora Guarantee Inc. | WR | WR | 3,715 | 1,514 | 161 | |||||||||||
Mitsui Sumitomo Insurance Co. Ltd. | A1 | A+ (3) | 2,033 | — | — | |||||||||||
ACA Financial Guaranty Corp. | NR (5) | WR | 746 | 2 | — | |||||||||||
Swiss Reinsurance Co. | Aa3 | AA- | 93 | — | — | |||||||||||
Ambac | WR | WR | 82 | 4,930 | 14,342 | |||||||||||
National Public Finance Guarantee Corporation | A3 | AA- | — | 6,210 | 5,894 | |||||||||||
MBIA | (4) | (4) | — | 2,613 | 587 | |||||||||||
FGIC | WR | WR | — | 2,074 | 834 | |||||||||||
Ambac Assurance Corp. Segregated Account | NR | NR | — | 109 | 956 | |||||||||||
CIFG Assurance North America Inc. ("CIFG") | WR | WR | — | 102 | 4,365 | |||||||||||
Other | Various | Various | 199 | 894 | 46 | |||||||||||
Total | $ | 22,975 | $ | 18,469 | $ | 27,886 | ||||||||||
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(1) | Includes par related to insured credit derivatives. |
(2) Represents “Withdrawn Rating.”
(3) The Company has structural collateral agreements satisfying the triple-A credit requirement of S&P and/or Moody’s.
(4) | MBIA includes subsidiaries MBIA Insurance Corp. rated B by S&P and B2 by Moody's and MBIA U.K. Insurance Ltd. rated B by S&P and Ba2 by Moody’s. |
(5) | Represents “Not Rated.” |
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Ceded Par Outstanding by Reinsurer and Credit Rating
As of December 31, 2014
Internal Credit Rating | |||||||||||||||||||||||||
Reinsurer | AAA | AA | A | BBB | BIG | Total | |||||||||||||||||||
(in millions) | |||||||||||||||||||||||||
American Overseas Reinsurance Company Limited (f/k/a Ram Re) | $ | 633 | $ | 2,452 | $ | 1,992 | $ | 1,158 | $ | 492 | $ | 6,727 | |||||||||||||
Tokio | 763 | 968 | 1,485 | 1,281 | 779 | 5,276 | |||||||||||||||||||
Radian Asset | 206 | 287 | 2,037 | 1,085 | 489 | 4,104 | |||||||||||||||||||
Syncora Guarantee Inc. | — | 291 | 498 | 2,193 | 733 | 3,715 | |||||||||||||||||||
Mitsui Sumitomo Insurance Co. Ltd. | 134 | 669 | 742 | 299 | 189 | 2,033 | |||||||||||||||||||
ACA Financial Guaranty Corp | — | 458 | 277 | 11 | — | 746 | |||||||||||||||||||
Swiss Reinsurance Co. | — | — | 0 | 26 | 67 | 93 | |||||||||||||||||||
Ambac | — | — | 82 | — | — | 82 | |||||||||||||||||||
Other | 62 | 82 | 55 | — | — | 199 | |||||||||||||||||||
Total | $ | 1,798 | $ | 5,207 | $ | 7,168 | $ | 6,053 | $ | 2,749 | $ | 22,975 | |||||||||||||
In accordance with U.S. statutory accounting requirements and U.S. insurance laws and regulations, in order for the Company to receive credit for liabilities ceded to reinsurers domiciled outside of the U.S., such reinsurers must secure their liabilities to the Company. All of the unauthorized reinsurers in the table above are required to post collateral for the benefit of the Company in an amount at least equal to the sum of their ceded unearned premium reserve, loss reserves and contingency reserves all calculated on a statutory basis of accounting. In addition, certain authorized reinsurers in the table above post collateral on terms negotiated with the Company. Collateral may be in the form of letters of credit or trust accounts. The total collateral posted by all non-affiliated reinsurers as of December 31, 2014 is approximately $610 million.
Second-to-Pay
Insured Par Outstanding by Internal Rating
As of December 31, 2014(1)
Public Finance | Structured Finance | ||||||||||||||||||||||||||||||||||||||||||
AAA | AA | A | BBB | BIG | AAA | AA | A | BBB | BIG | Total | |||||||||||||||||||||||||||||||||
(in millions) | |||||||||||||||||||||||||||||||||||||||||||
Radian Asset | $ | — | $ | — | $ | 3 | $ | 12 | $ | 6 | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 21 | |||||||||||||||||||||
Syncora Guarantee Inc. | — | 45 | 326 | 727 | 276 | 96 | — | — | — | 44 | 1,514 | ||||||||||||||||||||||||||||||||
ACA Financial Guaranty Corp. | — | 1 | — | 1 | — | — | — | — | — | — | 2 | ||||||||||||||||||||||||||||||||
Ambac | 30 | 1,301 | 2,597 | 637 | 63 | — | 1 | 64 | 231 | 6 | 4,930 | ||||||||||||||||||||||||||||||||
National Public Finance Guarantee Corporation | 160 | 2,193 | 3,833 | — | — | — | — | 24 | — | — | 6,210 | ||||||||||||||||||||||||||||||||
MBIA | — | 65 | 254 | 424 | — | — | 1,508 | — | 243 | 119 | 2,613 | ||||||||||||||||||||||||||||||||
FGIC | — | 77 | 975 | 281 | 302 | 371 | — | 25 | — | 43 | 2,074 | ||||||||||||||||||||||||||||||||
Ambac Assurance Corp. Segregated Account | — | — | — | — | — | — | 33 | — | — | 76 | 109 | ||||||||||||||||||||||||||||||||
CIFG | — | 4 | 51 | 22 | 25 | — | — | — | — | — | 102 | ||||||||||||||||||||||||||||||||
Other | — | 894 | — | — | — | — | — | — | — | — | 894 | ||||||||||||||||||||||||||||||||
Total | $ | 190 | $ | 4,580 | $ | 8,039 | $ | 2,104 | $ | 672 | $ | 467 | $ | 1,542 | $ | 113 | $ | 474 | $ | 288 | $ | 18,469 | |||||||||||||||||||||
____________________
(1) | Assured Guaranty’s internal rating. |
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Amounts Due (To) From Reinsurers
As of December 31, 2014
Assumed Premium, net of Commissions | Ceded Premium, net of Commissions | Assumed Expected Loss and LAE | Ceded Expected Loss and LAE | ||||||||||||
(in millions) | |||||||||||||||
American Overseas Reinsurance Company Limited (f/k/a Ram Re) | $ | — | $ | (8 | ) | $ | — | $ | 11 | ||||||
Tokio | — | (13 | ) | — | 46 | ||||||||||
Radian Asset | — | (13 | ) | — | 19 | ||||||||||
Syncora Guarantee Inc. | — | (29 | ) | — | 4 | ||||||||||
Mitsui Sumitomo Insurance Co. Ltd. | — | (3 | ) | — | 15 | ||||||||||
Swiss Reinsurance Co. | — | (3 | ) | — | 6 | ||||||||||
Ambac | 43 | — | (19 | ) | — | ||||||||||
National Public Finance Guarantee Corporation | 7 | — | (7 | ) | — | ||||||||||
MBIA | 5 | — | (9 | ) | — | ||||||||||
FGIC | 5 | — | (3 | ) | — | ||||||||||
Ambac Assurance Corp. Segregated Account | 13 | — | (83 | ) | — | ||||||||||
CIFG | — | — | (6 | ) | — | ||||||||||
Other | (2 | ) | (23 | ) | — | — | |||||||||
Total | $ | 71 | $ | (92 | ) | $ | (127 | ) | $ | 101 | |||||
Excess of Loss Reinsurance Facility
AGC, AGM and MAC entered into an aggregate excess of loss reinsurance facility with a number of reinsurers, effective as of January 1, 2014. The facility covers losses occurring either from January 1, 2014 through December 31, 2021, or January 1, 2015 through December 31, 2022, at the option of AGC, AGM and MAC. It terminates on January 1, 2016, unless AGC, AGM and MAC choose to extend it. The facility covers certain U.S. public finance credits insured or reinsured by AGC, AGM and MAC as of September 30, 2013, excluding credits that were rated non-investment grade as of December 31, 2013 by Moody’s or S&P or internally by AGC, AGM or MAC and is subject to certain per credit limits. Among the credits excluded are those associated with the Commonwealth of Puerto Rico and its related authorities and public corporations. The facility attaches when AGC’s, AGM’s and MAC’s net losses (net of AGC’s and AGM's reinsurance (including from affiliates) and net of recoveries) exceed $1.5 billion in the aggregate. The facility covers a portion of the next $500 million of losses, with the reinsurers assuming pro rata in the aggregate $450 million of the $500 million of losses and AGC, AGM and MAC jointly retaining the remaining $50 million of losses. The reinsurers are required to be rated at least AA- or to post collateral sufficient to provide AGM, AGC and MAC with the same reinsurance credit as reinsurers rated AA-. AGM, AGC and MAC are obligated to pay the reinsurers their share of recoveries relating to losses during the coverage period in the covered portfolio. AGC, AGM and MAC have paid approximately $19 million of premiums during 2014 for the term January 1, 2014 through December 31, 2014 and deposited approximately $19 million of securities into trust accounts for the benefit of the reinsurers to be used to pay the premium for January 1, 2015 through December 31, 2015.
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15. | Related Party Transactions |
The Company was party to transactions with entities that are affiliated with Wilbur L. Ross, Jr., who had been a director of the Company until November 21, 2014. Mr. Ross and the funds under his control owned approximately 8.2% of the AGL common shares as of December 31, 2013 and 10.2% as of December 31, 2012. However, in 2014, Mr. Ross and the funds sold all of the AGL shares they owned and Mr. Ross resigned from the AGL board. At the time of his resignation, WL Ross and Co. LLC issued a press release announcing that Mr. Ross had been elected Vice Chairman of Bank of Cyprus and, due to rules limiting directorships of bank officers, would be resigning from the boards of directors of several companies, including that of Assured Guaranty.
In addition, the Company retains Wellington Management Company, LLP, as investment manager for a portion of the Company's investment portfolio. Wellington Company LLP owned approximately 9.3% of the common shares of AGL as of December 31, 2014, 6.6% as of December 31, 2013 and 8.6% as of December 31, 2012.
The net expenses from transactions with these related parties were approximately $1.9 million in 2014, with no individual related party expense item exceeding $1.9 million, $2.5 million in 2013, with no individual related party expense item exceeding $1.9 million, and $3.4 million in 2012, with no individual related party expense item exceeding $2.0 million. As of December 31, 2014, 2013 and 2012 there were no significant amounts payable to or amounts receivable from related parties. In addition, please refer to Note 19, Shareholders' Equity, for a description of the transaction under which the Company purchased common shares from funds associated with WL Ross & Co. LLC and its affiliates and from Mr. Ross.
16. | Commitments and Contingencies |
Leases
AGL and its subsidiaries are party to various lease agreements accounted for as operating leases. The Company leases and occupies space in New York City through April 2026. In addition, AGL and its subsidiaries lease additional office space in various locations under non-cancelable operating leases which expire at various dates through 2021. Rent expense was $10.1 million in 2014, $9.9 million in 2013 and $10.0 million in 2012.
Future Minimum Rental Payments
Year | (in millions) | |||
2015 | $ | 8 | ||
2016 | 8 | |||
2017 | 8 | |||
2018 | 8 | |||
2019 | 8 | |||
Thereafter | 52 | |||
Total | $ | 92 | ||
Legal Proceedings
Lawsuits arise in the ordinary course of the Company’s business. It is the opinion of the Company’s management, based upon the information available, that the expected outcome of litigation against the Company, individually or in the aggregate, will not have a material adverse effect on the Company’s financial position or liquidity, although an adverse resolution of litigation against the Company in a fiscal quarter or year could have a material adverse effect on the Company’s results of operations in a particular quarter or year.
Accounting Policy
The Company establishes accruals for litigation and regulatory matters to the extent it is probable that a loss has been incurred and the amount of that loss can be reasonably estimated. For litigation and regulatory matters where a loss may be reasonably possible, but not probable, or is probable but not reasonably estimable, no accrual is established, but if the matter is material, it is disclosed, including matters discussed below. The Company reviews relevant information with respect to its litigation and regulatory matters on a quarterly, and annual basis and updates its accruals, disclosures and estimates of reasonably possible loss based on such reviews.
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In addition, in the ordinary course of their respective businesses, certain of the Company's subsidiaries assert claims in legal proceedings against third parties to recover losses paid in prior periods. For example, as described in the "Recovery Litigation," section of Note 6, Expected Loss to be Paid, in December 2008, the Company filed a claim in the Supreme Court of the State of New York against an investment manager in a transaction it insured alleging breach of fiduciary duty, gross negligence and breach of contract; discovery on the matter is ongoing. In the past, AGC and AGM have filed complaints against certain sponsors and underwriters of RMBS securities that AGC or AGM had insured, alleging that such persons had breached representations and warranties in the transaction documents, failed to cure or repurchase defective loans and/or violated state securities laws. The amounts, if any, the Company will recover in proceedings to recover losses are uncertain, and recoveries, or failure to obtain recoveries, in any one or more of these proceedings during any quarter or year could be material to the Company’s results of operations in that particular quarter or year.
Litigation
Proceedings Relating to the Company’s Financial Guaranty Business
The Company receives subpoenas duces tecum and interrogatories from regulators from time to time.
On November 28, 2011, Lehman Brothers International (Europe) (in administration) (“LBIE”) sued AGFP, an affiliate of AGC which in the past had provided credit protection to counterparties under credit default swaps. AGC acts as the credit support provider of AGFP under these credit default swaps. LBIE’s complaint, which was filed in the Supreme Court of the State of New York, alleged that AGFP improperly terminated nine credit derivative transactions between LBIE and AGFP and improperly calculated the termination payment in connection with the termination of 28 other credit derivative transactions between LBIE and AGFP. AGFP calculated that LBIE owes AGFP approximately $30 million in connection with the termination of the credit derivative transactions, whereas LBIE asserted in the complaint that AGFP owes LBIE a termination payment of approximately $1.4 billion. LBIE is seeking unspecified damages. On February 3, 2012, AGFP filed a motion to dismiss certain of the counts in the complaint, and on March 15, 2013, the court granted AGFP's motion to dismiss the count relating to improper termination of the nine credit derivative transactions and denied AGFP's motion to dismiss the count relating to the remaining transactions. Discovery has been ongoing and motions for summary judgment are due in September 2015. The Company cannot reasonably estimate the possible loss, if any, that may arise from this lawsuit.
On September 25, 2013, Wells Fargo Bank, N.A., as trust administrator of the MASTR Adjustable Rate Mortgages Trust 2007-3, filed an interpleader complaint in the U.S. District Court for the Southern District of New York against AGM, among others, relating to the right of AGM to be reimbursed from certain cashflows for principal claims paid in respect of insured certificates. The Company estimates that an adverse outcome to the interpleader proceeding could increase losses on the transaction by approximately $10 - $20 million, net of expected settlement payments and reinsurance in force.
Proceedings Resolved Since September 30, 2014
Beginning in July 2008, AGM and various other financial guarantors were named in complaints filed in the Superior Court for the State of California, City and County of San Francisco by a number of plaintiffs. Subsequently, plaintiffs' counsel filed amended complaints against AGM and AGC and added additional plaintiffs. These complaints alleged that the financial guaranty insurer defendants (i) participated in a conspiracy in violation of California's antitrust laws to maintain a dual credit rating scale that misstated the credit default risk of municipal bond issuers and created market demand for municipal bond insurance, (ii) participated in risky financial transactions in other lines of business that damaged each insurer's financial condition (thereby undermining the value of each of their guaranties), and (iii) failed to adequately disclose the impact of those transactions on their financial condition. In addition to their antitrust claims, various plaintiffs asserted claims for breach of the covenant of good faith and fair dealing, fraud, unjust enrichment, negligence, and negligent misrepresentation. On October 29, 2014, AGC and AGM filed a good faith settlement notice with the Superior Court for the State of California, City and County of San Francisco, informing the court and co-defendants that AGC, AGM and the plaintiffs had reached an agreement to settle and resolve the cases as between them. The plaintiffs agreed to dismiss the litigation in exchange for AGC and AGM waiving legal fees that had been awarded to them and making a payment to such plaintiffs. On December 12, 2014, the court entered an order determining that the parties had settled in good faith. Plaintiffs have submitted all appropriate dismissals to all courts, and AGC and AGM have submitted a dismissal for their cross-appeal.
On November 19, 2012, Lehman Brothers Holdings Inc. (“LBHI”) and Lehman Brothers Special Financing Inc. (“LBSF") commenced an adversary complaint and claim objection in the United States Bankruptcy Court for the Southern District of New York against Credit Protection Trust 283 (“CPT 283”), FSA Administrative Services, LLC, as trustee for CPT 283, and AGM, in connection with CPT 283's termination of a CDS between LBSF and CPT 283. CPT 283 terminated the CDS as a consequence of LBSF failing to make a scheduled payment owed to CPT 283, which termination occurred after
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LBHI filed for bankruptcy but before LBSF filed for bankruptcy. The CDS provided that CPT 283 was entitled to receive from LBSF a termination payment in that circumstance of approximately $43.8 million (representing the economic equivalent of the future fixed payments CPT 283 would have been entitled to receive from LBSF had the CDS not been terminated), and CPT 283 filed proofs of claim against LBSF and LBHI (as LBSF's credit support provider) for such amount. LBHI and LBSF sought to disallow and expunge (as impermissible and unenforceable penalties) CPT 283's proofs of claim against LBHI and LBSF and recover approximately $67.3 million, which LBHI and LBSF allege was the mark-to-market value of the CDS to LBSF (less unpaid amounts) on the day CPT 283 terminated the CDS, plus interest, attorney's fees, costs and other expenses. On the same day, LBHI and LBSF also commenced an adversary complaint and claim objection against Credit Protection Trust 207 (“CPT 207”), FSA Administrative Services, LLC, as trustee for CPT 207, and AGM, in connection with CPT 207's termination of a CDS between LBSF and CPT 207. Similarly, the CDS provided that CPT 207 was entitled to receive from LBSF a termination payment in that circumstance of $492,555. LBHI and LBSF seek to disallow and expunge CPT 207's proofs of claim against LBHI and LBSF and recover approximately $1.5 million. On January 30, 2015, the parties signed an agreement pursuant to which LBHI and LBSF dismissed their litigation related to CPT 283's and CPT 207's CDS terminations and the parties agreed that CPT 283 and CPT 207 have a total allowed claim in bankruptcy against LBSF and LBHI of $20 million.
Proceedings Related to AGMH’s Former Financial Products Business
The following is a description of legal proceedings involving AGMH’s former Financial Products Business. Although the Company did not acquire AGMH’s former Financial Products Business, which included AGMH’s former GIC business, medium term notes business and portions of the leveraged lease businesses, certain legal proceedings relating to those businesses are against entities that the Company did acquire. While Dexia SA and Dexia Crédit Local S.A., jointly and severally, have agreed to indemnify the Company against liability arising out of the proceedings described below, such indemnification might not be sufficient to fully hold the Company harmless against any injunctive relief or civil or criminal sanction that is imposed against AGMH or its subsidiaries.
Governmental Investigations into Former Financial Products Business
AGMH and/or AGM have received subpoenas duces tecum and interrogatories or civil investigative demands from the Attorneys General of the States of Connecticut, Florida, Illinois, Massachusetts, Missouri, New York, Texas and West Virginia relating to their investigations of alleged bid rigging of municipal GICs. AGMH has been responding to such requests. AGMH may receive additional inquiries from these or other regulators and expects to provide additional information to such regulators regarding their inquiries in the future. In addition,
• | AGMH received a subpoena from the Antitrust Division of the Department of Justice in November 2006 issued in connection with an ongoing criminal investigation of bid rigging of awards of municipal GICs and other municipal derivatives; and |
• | AGM received a subpoena from the SEC in November 2006 related to an ongoing industry-wide investigation concerning the bidding of municipal GICs and other municipal derivatives. |
Pursuant to the subpoenas, AGMH has furnished to the Department of Justice and SEC records and other information with respect to AGMH’s municipal GIC business. The ultimate loss that may arise from these investigations remains uncertain.
In July 2010, a former employee of AGM who had been involved in AGMH's former Financial Products Business was indicted along with two other persons with whom he had worked at Financial Guaranty Insurance Company. Such former employee and the other two persons were convicted on fraud conspiracy counts. After appeal, their convictions were reversed by a three-judge panel of the U.S. Court of Appeals for the Second Circuit in November 2013. In January 2014, the Department of Justice petitioned the U.S. Court of Appeals for the Second Circuit for a panel rehearing and a rehearing en banc of the appeal; the motion was denied on August 15, 2014, and the time period within which to petition for a writ of certiorari to the Supreme Court has expired.
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Lawsuits Relating to Former Financial Products Business
During 2008, nine putative class action lawsuits were filed in federal court alleging federal antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. These cases have been coordinated and consolidated for pretrial proceedings in the U.S. District Court for the Southern District of New York as MDL 1950, In re Municipal Derivatives Antitrust Litigation, Case No. 1:08-cv-2516 (“MDL 1950”). Five of these cases named both AGMH and AGM: (a) Hinds County, Mississippi v. Wachovia Bank, N.A.; (b) Fairfax County, Virginia v. Wachovia Bank, N.A.; (c) Central Bucks School District, Pennsylvania v. Wachovia Bank, N.A.; (d) Mayor and City Council of Baltimore, Maryland v. Wachovia Bank, N.A.; and (e) Washington County, Tennessee v. Wachovia Bank, N.A. In April 2009, the MDL 1950 court granted the defendants’ motion to dismiss on the federal claims, but granted leave for the plaintiffs to file an amended complaint. The Corrected Third Consolidated Amended Class Action Complaint, filed on October 9, 2013, lists neither AGM nor AGMH as a named defendant or a co-conspirator. The complaint generally seeks unspecified monetary damages, interest, attorneys’ fees and other costs. The other four cases named AGMH (but not AGM) and also alleged that the defendants violated California state antitrust law and common law by engaging in illegal bid-rigging and market allocation, thereby depriving the cities or municipalities of competition in the awarding of GICs and ultimately resulting in the cities paying higher fees for these products: (f) City of Oakland, California v. AIG Financial Products Corp.; (g) County of Alameda, California v. AIG Financial Products Corp.; (h) City of Fresno, California v. AIG Financial Products Corp.; and (i) Fresno County Financing Authority v. AIG Financial Products Corp. When the four plaintiffs filed a consolidated complaint in September 2009, the plaintiffs did not name AGMH as a defendant. However, the complaint does describe some of AGMH’s and AGM’s activities. The consolidated complaint generally seeks unspecified monetary damages, interest, attorneys’ fees and other costs. In April 2010, the MDL 1950 court granted in part and denied in part the named defendants’ motions to dismiss this consolidated complaint. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from these lawsuits.
In 2008, AGMH and AGM also were named in five non-class action lawsuits originally filed in the California Superior Courts alleging violations of California law related to the municipal derivatives industry: (a) City of Los Angeles, California v. Bank of America, N.A.; (b) City of Stockton, California v. Bank of America, N.A.; (c) County of San Diego, California v. Bank of America, N.A.; (d) County of San Mateo, California v. Bank of America, N.A.; and (e) County of Contra Costa, California v. Bank of America, N.A. Amended complaints in these actions were filed in September 2009, adding a federal antitrust claim and naming AGM (but not AGMH) and AGUS, among other defendants. These cases have been transferred to the Southern District of New York and consolidated with MDL 1950 for pretrial proceedings. In late 2009, AGM and AGUS, among other defendants, were named in six additional non-class action cases filed in federal court, which also have been coordinated and consolidated for pretrial proceedings with MDL 1950: (f) City of Riverside, California v. Bank of America, N.A.; (g) Sacramento Municipal Utility District v. Bank of America, N.A.; (h) Los Angeles World Airports v. Bank of America, N.A.; (i) Redevelopment Agency of the City of Stockton v. Bank of America, N.A.; (j) Sacramento Suburban Water District v. Bank of America, N.A.; and (k) County of Tulare, California v. Bank of America, N.A. The MDL 1950 court denied AGM and AGUS’s motions to dismiss these eleven complaints in April 2010. Amended complaints were filed in May 2010. On October 29, 2010, AGM and AGUS were voluntarily dismissed with prejudice from the Sacramento Municipal Utility District case only. The complaints in these lawsuits generally seek or sought unspecified monetary damages, interest, attorneys’ fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from the remaining lawsuits.
In May 2010, AGM and AGUS, among other defendants, were named in five additional non-class action cases filed in federal court in California: (a) City of Richmond, California v. Bank of America, N.A. (filed on May 18, 2010, N.D. California); (b) City of Redwood City, California v. Bank of America, N.A. (filed on May 18, 2010, N.D. California); (c) Redevelopment Agency of the City and County of San Francisco, California v. Bank of America, N.A. (filed on May 21, 2010, N.D. California); (d) East Bay Municipal Utility District, California v. Bank of America, N.A. (filed on May 18, 2010, N.D. California); and (e) City of San Jose and the San Jose Redevelopment Agency, California v. Bank of America, N.A (filed on May 18, 2010, N.D. California). These cases have also been transferred to the Southern District of New York and consolidated with MDL 1950 for pretrial proceedings. In September 2010, AGM and AGUS, among other defendants, were named in a sixth additional non-class action filed in federal court in New York, but which alleges violation of New York’s Donnelly Act in addition to federal antitrust law: Active Retirement Community, Inc. d/b/a Jefferson’s Ferry v. Bank of America, N.A. (filed on September 21, 2010, E.D. New York), which has also been transferred to the Southern District of New York and consolidated with MDL 1950 for pretrial proceedings. In December 2010, AGM and AGUS, among other defendants, were named in a seventh additional non-class action filed in federal court in the Central District of California, Los Angeles Unified School District v. Bank of America, N.A., and in an eighth additional non-class action filed in federal court in the Southern District of New York, Kendal on Hudson, Inc. v. Bank of America, N.A. These cases also have been consolidated with MDL 1950 for pretrial proceedings. The complaints in these lawsuits generally seek unspecified monetary damages, interest, attorneys’ fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from these lawsuits.
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In January 2011, AGM and AGUS, among other defendants, were named in an additional non-class action case filed in federal court in New York, which alleges violation of New York’s Donnelly Act in addition to federal antitrust law: Peconic Landing at Southold, Inc. v. Bank of America, N.A. This case has been consolidated with MDL 1950 for pretrial proceedings. The complaint in this lawsuit generally seeks unspecified monetary damages, interest, attorneys’ fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from this lawsuit.
In September 2009, the Attorney General of the State of West Virginia filed a lawsuit (Circuit Ct. Mason County, W. Va.) against Bank of America, N.A. alleging West Virginia state antitrust violations in the municipal derivatives industry, seeking damages and alleging, among other things, a conspiracy to fix the pricing of, and manipulate bids for, municipal derivatives, including GICs. An amended complaint in this action was filed in June 2010, adding a federal antitrust claim and naming AGM (but not AGMH) and AGUS, among other defendants. This case has been removed to federal court as well as transferred to the S.D.N.Y. and consolidated with MDL 1950 for pretrial proceedings. AGM and AGUS answered West Virginia's Second Amended Complaint on November 11, 2013. The complaint in this lawsuit generally seeks civil penalties, unspecified monetary damages, interest, attorneys’ fees, costs and other expenses. The Company cannot reasonably estimate the possible loss, if any, or range of loss that may arise from this lawsuit.
17. | Long-Term Debt and Credit Facilities |
The Company has outstanding long-term debt issued by AGUS and AGMH. AGUS has issued 7.0% Senior Notes, 5.0% Senior Notes and Series A, Enhanced Junior Subordinated Debentures. AGMH has issued 6 7/8% Quarterly Income Bonds Securities (“QUIBS”), 6.25% Notes and 5.60% Notes, as well $300 million Junior Subordinated Debentures. All of such debt is fully and unconditionally guaranteed by AGL; AGL's guarantee of the junior subordinated debentures is on a junior subordinated basis.
In addition, refinancing vehicles consolidated by AGM issued notes payable to the Financial Products Companies now owned by Dexia; the refinancing vehicles borrowed the funds in order to purchase assets underlying obligations insured by AGM. See Note 11, Investments and Cash.
Accounting Policy
Long-term debt is recorded at principal amounts net of any unamortized original issue discount or premium and unamortized fair value adjustment for AGMH debt (as of the date of the AGMH acquisition). Discount is accreted into interest expense over the life of the applicable debt.
Debt Issued by AGUS
7.0% Senior Notes. On May 18, 2004, AGUS issued $200 million of 7.0% senior notes due 2034 (“7.0% Senior Notes”) for net proceeds of $197 million. Although the coupon on the Senior Notes is 7.0%, the effective rate is approximately 6.4%, taking into account the effect of a cash flow hedge executed by the Company in March 2004.
5.0% Senior Notes. On June 20, 2014, AGUS issued $500 million of 5.0% Senior Notes due 2024 ("5.0% Senior Notes") for net proceeds of $495 million. The notes are guaranteed by AGL. The net proceeds from the sale of the notes are being used for general corporate purposes, including the purchase of AGL common shares.
8.5% Senior Notes. On June 24, 2009, AGL issued 3,450,000 equity units for net proceeds of approximately $167 million in a registered public offering. The net proceeds of the offering were used to pay a portion of the consideration for the acquisition of AGMH. Each equity unit consisted of (i) a 5.0% undivided beneficial ownership interest in $1,000 principal amount of 8.5% senior notes due 2014 issued by AGUS and (ii) a forward purchase contract obligating the holders to purchase $50 of AGL common shares in June 2012. On June 1, 2012, the Company completed the remarketing of the $173 million aggregate principal amount of 8.5% Senior Notes; AGUS purchased all of the Senior Notes in the remarketing at a price of 100% of the principal amount thereof, and retired all of such notes on June 1, 2012. The proceeds from the remarketing were used to satisfy the obligations of the holders of the Equity Units to purchase AGL common shares pursuant to the forward purchase contract. Accordingly, on June 1, 2012, AGL issued 3.8924 common shares to holders of each Equity Unit, which represented a settlement rate of 3.8685 common shares plus certain anti-dilution adjustments, or an aggregate of 13,428,770 common shares at approximately $12.85 per share. The Equity Units ceased to exist when the forward purchase contracts were settled on June 1, 2012.
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Series A Enhanced Junior Subordinated Debentures. On December 20, 2006, AGUS issued $150 million of the Debentures due 2066. The Debentures pay a fixed 6.40% rate of interest until December 15, 2016, and thereafter pay a floating rate of interest, reset quarterly, at a rate equal to three month LIBOR plus a margin equal to 2.38%. AGUS may select at one or more times to defer payment of interest for one or more consecutive periods for up to ten years. Any unpaid interest bears interest at the then applicable rate. AGUS may not defer interest past the maturity date.
Debt Issued by AGMH
6 7/8% QUIBS. On December 19, 2001, AGMH issued $100 million face amount of 6 7/8% QUIBS due December 15, 2101, which are callable without premium or penalty.
6.25% Notes. On November 26, 2002, AGMH issued $230 million face amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part.
5.60% Notes. On July 31, 2003, AGMH issued $100 million face amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part.
Junior Subordinated Debentures. On November 22, 2006, AGMH issued $300 million face amount of Junior Subordinated Debentures with a scheduled maturity date of December 15, 2036 and a final repayment date of December 15, 2066. The final repayment date of December 15, 2066 may be automatically extended up to four times in five-year increments provided certain conditions are met. The debentures are redeemable, in whole or in part, at any time prior to December 15, 2036 at their principal amount plus accrued and unpaid interest to the date of redemption or, if greater, the make-whole redemption price. Interest on the debentures will accrue from November 22, 2006 to December 15, 2036 at the annual rate of 6.40%. If any amount of the debentures remains outstanding after December 15, 2036, then the principal amount of the outstanding debentures will bear interest at a floating interest rate equal to one-month LIBOR plus 2.215% until repaid. AGMH may elect at one or more times to defer payment of interest on the debentures for one or more consecutive interest periods that do not exceed ten years. In connection with the completion of this offering, AGMH entered into a replacement capital covenant for the benefit of persons that buy, hold or sell a specified series of AGMH long-term indebtedness ranking senior to the debentures. Under the covenant, the debentures will not be repaid, redeemed, repurchased or defeased by AGMH or any of its subsidiaries on or before the date that is 20 years prior to the final repayment date, except to the extent that AGMH has received proceeds from the sale of replacement capital securities. The proceeds from this offering were used to pay a dividend to the shareholders of AGMH.
Debt Issued by AGM
In order to mitigate certain financial guaranty insurance losses, special purpose entities that AGM consolidates ("refinancing vehicles") borrowed funds from the former AGMH subsidiaries that conducted AGMH’s Financial Products Business (the “Financial Products Companies”). The Company refers to such debt as the "Notes Payable." The Financial Products Companies issued GICs that AGM insured, and loaned the proceeds to the refinancing vehicles. The refinancing vehicles used the proceeds from the Notes Payable to purchase certain obligations insured by AGM or collateral underlying such obligations and reimbursed AGM for its claim payments, in exchange for AGM assigning to the refinancing vehicles certain of its rights against the trusts in the applicable transactions.
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The principal and carrying values of the Company’s long-term debt are presented in the table below.
Principal and Carrying Amounts of Debt
As of December 31, 2014 | As of December 31, 2013 | ||||||||||||||
Principal | Carrying Value | Principal | Carrying Value | ||||||||||||
(in millions) | |||||||||||||||
AGUS: | |||||||||||||||
7.0% Senior Notes | $ | 200 | $ | 198 | $ | 200 | $ | 198 | |||||||
5.0% Senior Notes | 500 | 499 | — | — | |||||||||||
Series A Enhanced Junior Subordinated Debentures | 150 | 150 | 150 | 150 | |||||||||||
Total AGUS | 850 | 847 | 350 | 348 | |||||||||||
AGMH: | |||||||||||||||
67/8% QUIBS | 100 | 68 | 100 | 68 | |||||||||||
6.25% Notes | 230 | 139 | 230 | 138 | |||||||||||
5.60% Notes | 100 | 55 | 100 | 55 | |||||||||||
Junior Subordinated Debentures | 300 | 175 | 300 | 169 | |||||||||||
Total AGMH | 730 | 437 | 730 | 430 | |||||||||||
AGM: | |||||||||||||||
Notes Payable | 16 | 19 | 34 | 38 | |||||||||||
Total AGM | 16 | 19 | 34 | 38 | |||||||||||
Total | $ | 1,596 | $ | 1,303 | $ | 1,114 | $ | 816 | |||||||
Principal payments due under the long-term debt are as follows:
Expected Maturity Schedule of Debt
Expected Withdrawal Date | AGUS | AGMH | AGM | Total | ||||||||||||
(in millions) | ||||||||||||||||
2015 | $ | — | $ | — | $ | 7 | $ | 7 | ||||||||
2016 | — | — | 3 | 3 | ||||||||||||
2017 | — | — | 3 | 3 | ||||||||||||
2018 | — | — | 2 | 2 | ||||||||||||
2019 | — | — | 1 | 1 | ||||||||||||
2020-2039 | 700 | — | — | 700 | ||||||||||||
2040-2059 | — | — | — | — | ||||||||||||
2060-2079 | 150 | 300 | — | 450 | ||||||||||||
Thereafter | — | 430 | — | 430 | ||||||||||||
Total | $ | 850 | $ | 730 | $ | 16 | $ | 1,596 | ||||||||
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Interest Expense
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
AGUS: | |||||||||||
7.0% Senior Notes | $ | 13 | $ | 13 | $ | 13 | |||||
5.0% Senior Notes | 13 | — | — | ||||||||
8.50% Senior Notes | — | — | 8 | ||||||||
Series A Enhanced Junior Subordinated Debentures | 10 | 10 | 10 | ||||||||
Total AGUS | 36 | 23 | 31 | ||||||||
AGMH: | |||||||||||
67/8% QUIBS | 7 | 7 | 7 | ||||||||
6.25% Notes | 16 | 16 | 16 | ||||||||
5.60% Notes | 6 | 6 | 6 | ||||||||
Junior Subordinated Debentures | 25 | 25 | 25 | ||||||||
Total AGMH | 54 | 54 | 54 | ||||||||
AGM: | |||||||||||
Notes Payable | 2 | 5 | 7 | ||||||||
Total AGM | 2 | 5 | 7 | ||||||||
Total | $ | 92 | $ | 82 | $ | 92 | |||||
Recourse Credit Facilities
2009 Strip Coverage Facility
In connection with the Company's acquisition of AGMH and its subsidiaries from Dexia Holdings Inc., AGM agreed to retain the risks relating to the debt and strip policy portions of the leveraged lease business. The liquidity risk to AGM related to the strip policy portion of the leveraged lease business is mitigated by the strip coverage facility described below.
In a leveraged lease transaction, a tax-exempt entity (such as a transit agency) transfers tax benefits to a tax-paying entity by transferring ownership of a depreciable asset, such as subway cars. The tax-exempt entity then leases the asset back from its new owner.
If the lease is terminated early, the tax-exempt entity must make an early termination payment to the lessor. A portion of this early termination payment is funded from monies that were pre-funded and invested at the closing of the leveraged lease transaction (along with earnings on those invested funds). The tax-exempt entity is obligated to pay the remaining, unfunded portion of this early termination payment (known as “strip coverage”) from its own sources. AGM issued financial guaranty insurance policies (known as “strip policies”) that guaranteed the payment of these unfunded strip coverage amounts to the lessor, in the event that a tax-exempt entity defaulted on its obligation to pay this portion of its early termination payment. AGM can then seek reimbursement of its strip policy payments from the tax-exempt entity, and can also sell the transferred depreciable asset and reimburse itself from the sale proceeds.
Currently, all the leveraged lease transactions in which AGM acts as strip coverage provider are breaching a rating trigger related to AGM and are subject to early termination. However, early termination of a lease does not result in a draw on the AGM policy if the tax-exempt entity makes the required termination payment. If all the leases were to terminate early and the tax-exempt entities do not make the required early termination payments, then AGM would be exposed to possible liquidity claims on gross exposure of approximately $1.2 billion as of December 31, 2014. To date, none of the leveraged lease transactions that involve AGM has experienced an early termination due to a lease default and a claim on the AGM policy. It is difficult to determine the probability that AGM will have to pay strip provider claims or the likely aggregate amount of such claims. At December 31, 2014, approximately $1.4 billion of cumulative strip par exposure had been terminated since 2008 on a consensual basis. The consensual terminations have resulted in no claims on AGM.
On July 1, 2009, AGM and Dexia Crédit Local S.A., acting through its New York Branch (“Dexia Crédit Local (NY)”), entered into a credit facility (the “Strip Coverage Facility”). Under the Strip Coverage Facility, Dexia Crédit Local
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(NY) agreed to make loans to AGM to finance all draws made by lessors on AGM strip policies that were outstanding as of November 13, 2008, up to the commitment amount. The commitment amount of the Strip Coverage Facility was $1 billion at closing of the Company's acquisition of AGMH. AGM has reduced the maximum commitment amount from time to time, after taking into account its experience with its exposure to leveraged lease transactions. Most recently, as of June 30, 2014, AGM reduced the maximum commitment amount to $495 million and agreed with Dexia Crédit Local (NY) that the commitment amount would no longer amortize on a scheduled monthly basis.
Fundings under this facility are subject to certain conditions precedent, and their repayment is collateralized by a security interest that AGM granted to Dexia Crédit Local (NY) in amounts that AGM recovers—from the tax-exempt entity, or from asset sale proceeds—following its payment of strip policy claims. On June 30, 2014, AGM and Dexia Crédit Local (NY) agreed to shorten the duration of the facility. Accordingly, the Strip Coverage Facility will terminate upon the earliest to occur of an AGM change of control, the reduction of the commitment amount to $0 in accordance with the terms of the facility, and June 30, 2024 (rather than the original maturity date of January 31, 2042).
The Strip Coverage Facility’s financial covenants require that AGM and its subsidiaries maintain:
• | a maximum debt-to-capital ratio of 30%; and |
• | a minimum net worth of 75% of consolidated net worth as of July 1, 2009, plus, beginning June 30, 2015 and on each anniversary of such date, an amount equal to the product of (i) 25% of the aggregate consolidated net income (or loss) for the period beginning July 2, 2009 and ending on June 30, 2014 and (ii) a fraction, the numerator of which is the commitment amount as of the relevant calculation date and the denominator of which is $1 billion. |
The Company was in compliance with all financial covenants as of December 31, 2014.
The Strip Coverage Facility contains restrictions on AGM, including, among other things, in respect of its ability to incur debt, permit liens, pay dividends or make distributions, dissolve or become party to a merger or consolidation. Most of these restrictions are subject to exceptions. The Strip Coverage Facility has customary events of default, including (subject to certain materiality thresholds and grace periods) payment default, bankruptcy or insolvency proceedings and cross-default to other debt agreements.
As of December 31, 2014, no amounts were outstanding under this facility, nor have there been any borrowings during the life of this facility.
Intercompany Credit Facility
On October 25, 2013, AGL, as borrower, and AGUS, as lender, entered into a revolving credit facility pursuant to which AGL may, from time to time, borrow for general corporate purposes. Under the credit facility, AGUS committed to lend a principal amount not exceeding $225 million in the aggregate. Such commitment terminates on the October 25, 2018 (the “loan termination date”). The unpaid principal amount of each loan will bear interest at a fixed rate equal to 100% of the then applicable Federal short-term or mid-term interest rate, as the case may be, as determined under Internal Revenue Code Sec. 1274(d), and interest on all loans will be computed for the actual number of days elapsed on the basis of a year consisting of 360 days. Accrued interest on all loans will be paid on the last day of each June and December, beginning on December 31, 2013, and at maturity. AGL must repay the then unpaid principal amounts of the loans by the third anniversary of the loan termination date. No amounts are currently outstanding under the credit facility.
Committed Capital Securities
On April 8, 2005, AGC entered into separate agreements (the “Put Agreements”) with four custodial trusts (each, a “Custodial Trust”) pursuant to which AGC may, at its option, cause each of the Custodial Trusts to purchase up to $50 million of perpetual preferred stock of AGC (the “AGC Preferred Stock”). The custodial trusts were created as a vehicle for providing capital support to AGC by allowing AGC to obtain immediate access to new capital at its sole discretion at any time through the exercise of the put option. If the put options were exercised, AGC would receive $200 million in return for the issuance of its own perpetual preferred stock, the proceeds of which may be used for any purpose, including the payment of claims. The put options have not been exercised through the date of this filing.
Distributions on the AGC CCS are determined pursuant to an auction process. On April 7, 2008 this auction process failed, thereby increasing the annualized rate on the AGC CCS to one-month LIBOR plus 250 basis points. Distributions on the AGC preferred stock will be determined pursuant to the same process.
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In June 2003, $200 million of “AGM CPS”, money market preferred trust securities, were issued by trusts created for the primary purpose of issuing the AGM CPS, investing the proceeds in high-quality commercial paper and selling put options to AGM, allowing AGM to issue the trusts non-cumulative redeemable perpetual preferred stock (the “AGM Preferred Stock”) of AGM in exchange for cash. There are four trusts, each with an initial aggregate face amount of $50 million. These trusts hold auctions every 28 days, at which time investors submit bid orders to purchase AGM CPS. If AGM were to exercise a put option, the applicable trust would transfer the portion of the proceeds attributable to principal received upon maturity of its assets, net of expenses, to AGM in exchange for AGM Preferred Stock. AGM pays a floating put premium to the trusts, which represents the difference between the commercial paper yield and the winning auction rate (plus all fees and expenses of the trust). If an auction does not attract sufficient clearing bids, however, the auction rate is subject to a maximum rate of one-month LIBOR plus 200 basis points for the next succeeding distribution period. Beginning in August 2007, the AGM CPS required the maximum rate for each of the relevant trusts. AGM continues to have the ability to exercise its put option and cause the related trusts to purchase AGM Preferred Stock. The trusts provide AGM access to new capital at its sole discretion through the exercise of the put options. As of December 31, 2014 the put option had not been exercised. The Company does not consider itself to be the primary beneficiary of the trusts. See Note 8, Fair Value Measurement, –Other Assets–Committed Capital Securities, for a fair value measurement discussion.
18. | Earnings Per Share |
Accounting Policy
The Company computes earnings per share ("EPS") using a two-class method by including participating securities which entitle their holders to receive nonforfeitable dividends or dividend equivalents before vesting. Restricted stock awards and share units under the AGC supplemental employee retirement plan ("SERP") plan are considered participating securities as they received non-forfeitable rights to dividends at the same rate as common stock.
The two-class method of computing EPS is an earnings allocation formula that determines EPS for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. Basic EPS is then calculated by dividing net (loss) income available to common shareholders of Assured Guaranty by the weighted‑average number of common shares outstanding during the period. Diluted EPS adjusts basic EPS for the effects of restricted stock, stock options, equity units and other potentially dilutive financial instruments (“dilutive securities”), only in the periods in which such effect is dilutive. The effect of the dilutive securities is reflected in diluted EPS by application of the more dilutive of (1) the treasury stock method or (2) the two-class method assuming nonvested shares are not converted into common shares. With respect to the equity units, which were settled on June 1, 2012 (see Note 17, Long-Term Debt and Credit Facilities), the Company used the treasury stock method in computing diluted EPS. Equity forwards were included in the calculation of basic EPS when such forward contracts were satisfied and the holders thereof became common stock holders. The Company has a single class of common stock.
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Computation of Earnings Per Share
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions, except per share amounts) | |||||||||||
Basic EPS: | |||||||||||
Net income (loss) attributable to AGL | $ | 1,088 | $ | 808 | 110 | ||||||
Less: Distributed and undistributed income (loss) available to nonvested shareholders | 0 | 1 | 0 | ||||||||
Distributed and undistributed income (loss) available to common shareholders of AGL and subsidiaries, basic | $ | 1,088 | $ | 807 | 110 | ||||||
Basic shares | 172.6 | 186.6 | 189.2 | ||||||||
Basic EPS | $ | 6.30 | $ | 4.32 | $ | 0.58 | |||||
Diluted EPS: | |||||||||||
Distributed and undistributed income (loss) available to common shareholders of AGL and subsidiaries, basic | $ | 1,088 | $ | 807 | $ | 110 | |||||
Plus: Re-allocation of undistributed income (loss) available to nonvested shareholders of AGL and subsidiaries | 0 | 0 | 0 | ||||||||
Distributed and undistributed income (loss) available to common shareholders of AGL and subsidiaries, diluted | $ | 1,088 | $ | 807 | $ | 110 | |||||
Basic shares | 172.6 | 186.6 | 189.2 | ||||||||
Effect of dilutive securities: | |||||||||||
Options and restricted stock awards | 1.0 | 1.0 | 0.8 | ||||||||
Equity units | — | — | 0.7 | ||||||||
Diluted shares | 173.6 | 187.6 | 190.7 | ||||||||
Diluted EPS | $ | 6.26 | $ | 4.30 | $ | 0.57 | |||||
Potentially dilutive securities excluded from computation of EPS because of antidilutive effect | 1.6 | 2.7 | 9.9 | ||||||||
19. | Shareholders' Equity |
Share Issuances
AGL has authorized share capital of $5 million divided into 500,000,000 shares, par value $0.01 per share. Except as described below, AGL's common shares have no preemptive rights or other rights to subscribe for additional common shares, no rights of redemption, conversion or exchange and no sinking fund rights. In the event of liquidation, dissolution or winding-up, the holders of AGL's common shares are entitled to share equally, in proportion to the number of common shares held by such holder, in AGL's assets, if any remain after the payment of all its liabilities and the liquidation preference of any outstanding preferred shares. Under certain circumstances, AGL has the right to purchase all or a portion of the shares held by a shareholder at fair market value. All of the common shares are fully paid and non assessable. Holders of AGL's common shares are entitled to receive dividends as lawfully may be declared from time to time by AGL's Board of Directors.
In general, and except as provided below, shareholders have one vote for each common share held by them and are entitled to vote with respect to their fully paid shares at all meetings of shareholders. However, if, and so long as, the common shares (and other of AGL's shares) of a shareholder are treated as "controlled shares" (as determined pursuant to section 958 of the Code) of any U.S. Person and such controlled shares constitute 9.5% or more of the votes conferred by AGL's issued and outstanding shares, the voting rights with respect to the controlled shares owned by such U.S. Person shall be limited, in the aggregate, to a voting power of less than 9.5% of the voting power of all issued and outstanding shares, under a formula specified in AGL's Bye-laws. The formula is applied repeatedly until there is no U.S. Person whose controlled shares constitute 9.5% or more of the voting power of all issued and outstanding shares and who generally would be required to recognize income with respect to AGL under the Code if AGL were a controlled foreign corporation as defined in the Code and if the ownership threshold under the Code were 9.5% (as defined in AGL's Bye-Laws as a "9.5% U.S. Shareholder").
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Subject to AGL's Bye-Laws and Bermuda law, AGL's Board of Directors has the power to issue any of AGL's unissued shares as it determines, including the issuance of any shares or class of shares with preferred, deferred or other special rights.
Issuance of Shares
Number of Shares | Price per Share | Proceeds | Net Proceeds | |||||||||||
(in millions, except share and per share amounts) | ||||||||||||||
June 1, 2012(1) | 13,428,770 | $ | 12.85 | $ | 173 | $ | 173 | |||||||
____________________
(1) | Relates to the settlement of forward purchase contracts. See Note 17, Long-Term Debt and Credit Facilities. |
Under AGL's Bye-Laws and subject to Bermuda law, if AGL's Board of Directors determines that any ownership of AGL's shares may result in adverse tax, legal or regulatory consequences to the Company, any of the Company's subsidiaries or any of its shareholders or indirect holders of shares or its Affiliates (other than such as AGL's Board of Directors considers de minimis), the Company has the option, but not the obligation, to require such shareholder to sell to AGL or to a third party to whom AGL assigns the repurchase right the minimum number of common shares necessary to avoid or cure any such adverse consequences at a price determined in the discretion of the Board of Directors to represent the shares' fair market value (as defined in AGL's Bye-Laws). In addition, AGL's Board of Directors may determine that shares held carry different voting rights when it deems it appropriate to do so to (i) avoid the existence of any 9.5% U.S. Shareholder; and (ii) avoid adverse tax, legal or regulatory consequences to AGL or any of its subsidiaries or any direct or indirect holder of shares or its affiliates. "Controlled shares" includes, among other things, all shares of AGL that such U.S. Person is deemed to own directly, indirectly or constructively (within the meaning of section 958 of the Code). Further, these provisions do not apply in the event one shareholder owns greater than 75% of the voting power of all issued and outstanding shares.
Under these provisions, certain shareholders may have their voting rights limited to less than one vote per share, while other shareholders may have voting rights in excess of one vote per share. Moreover, these provisions could have the effect of reducing the votes of certain shareholders who would not otherwise be subject to the 9.5% limitation by virtue of their direct share ownership. AGL's Bye-laws provide that it will use its best efforts to notify shareholders of their voting interests prior to any vote to be taken by them.
Share Repurchases
As of December 31, 2014, the Company's share repurchase authorization was $210 million. The Company expects the repurchases to be made from time to time in the open market or in privately negotiated transactions. The timing, form and amount of the share repurchases under the program are at the discretion of management and will depend on a variety of factors, including availability of funds at the holding companies, market conditions, the Company's capital position, legal requirements and other factors. The repurchase program may be modified, extended or terminated by the Board of Directors at any time. It does not have an expiration date. In 2014, the Company repurchased a total of 24.4 million common shares for approximately $590 million at an average price of $24.17 per share. The 2013 share repurchases included 5.0 million common shares purchased on June 5, 2013 from funds associated with WL Ross & Co. LLC and its affiliates (collectively, the “WLR Funds”) and Wilbur L. Ross, Jr., a director of the Company, for $109.7 million.
Share Repurchases
Year | Number of Shares Repurchased | Total Payments (in millions) | Average Price Paid Per Share | ||||||||
2015 (through February 26, 2015 on a settlement date basis) | 3,581,767 | $ | 92 | $ | 25.63 | ||||||
2014 | 24,413,781 | $ | 590 | $ | 24.17 | ||||||
2013 | 12,512,759 | 264 | 21.12 | ||||||||
2012 | 2,066,759 | 24 | 11.76 | ||||||||
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Deferred Compensation
Each of the Chief Executive Officer and the General Counsel of the Company has elected to invest a portion of his AGL supplemental employee retirement plan ("SERP") account in the employer stock fund within the SERP. Each unit in the employer stock fund represents the right to receive one AGL common share upon a distribution from the SERP. Each unit equals the number of AGL common shares which could have been purchased with the value of the account deemed invested in the employer stock fund as of the date of such election. The election to invest in the employer stock fund is irrevocable (i.e., any portion of a SERP account allocated to the employer stock fund and invested in units shall remain allocated to the employer stock fund until the participant receives a distribution from SERP). At the same time such investment elections were made, the Company purchased AGL common shares and placed such shares in trust to be distributed to the Chief Executive Officer and the General Counsel upon a distribution from the SERP in settlement of their units invested in the employer stock fund. As of December 31, 2014 and 2013, the Company had 320,193 and 320,193 shares, respectively, in the trust. The Company recorded the purchase of such shares in “deferred equity compensation” in the consolidated balance sheet.
Certain executives of the Company elected to invest a portion of their AGC SERP accounts in the employer stock fund in the AGC SERP. Each unit in the employer stock fund represents the right to receive one AGL common share upon a distribution from the AGC SERP. Each unit equals the number of AGL common shares which could have been purchased with the value of the account deemed invested in the employer stock fund as of the date of such election. As of December 31, 2014 and 2013, there were 74,309 and 74,309 units, respectively, in the AGC SERP. See Note 20, Employee Benefit Plans.
Dividends
Any determination to pay cash dividends is at the discretion of the Company's Board of Directors, and depends upon the Company's results of operations and operating cash flows, its financial position and capital requirements, general business conditions, legal, tax, regulatory, rating agency and contractual restrictions on the payment of dividends, and any other factors the Company's Board of Directors deems relevant. For more information concerning regulatory constraints that affect the Company's ability to pay dividends, see Note 12, Insurance Company Regulatory Requirements.
On February 4, 2015, the Company declared a quarterly dividend of $0.12 per common share, an increase of 9% from a quarterly dividend of $0.11 per common share paid in 2014. On February 5, 2014, the Company declared a quarterly dividend of $0.11 per common share, an increase of 10% from a quarterly dividend of $0.10 per common share paid in 2013. On February 7, 2013, the Company declared a quarterly dividend of $0.10 per common share, an increase of 11% from a quarterly dividend of $0.09 per common share paid in 2012.
20. | Employee Benefit Plans |
Accounting Policy
The expense for Performance Retention Plan awards is recognized straight-line over the requisite service period, with the exception of retirement eligible employees. For retirement eligible employees, the expense is recognized immediately.
Share-based compensation expense is based on the grant date fair value using the grant date closing price, the lattice, Monte Carlo or Black-Scholes pricing models. The Company amortizes the fair value of share-based awards on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods, with the exception of retirement‑eligible employees. For retirement-eligible employees, certain awards contain retirement provisions and therefore are amortized over the period through the date the employee first becomes eligible to retire and is no longer required to provide service to earn part or all of the award.
The fair value of each award under the Assured Guaranty Ltd. Employee Stock Purchase Plan is estimated at the beginning of each offering period using the Black-Scholes option valuation model.
Assured Guaranty Ltd. 2004 Long-Term Incentive Plan
Under the Assured Guaranty Ltd. 2004 Long-Term Incentive Plan, as amended (the “Incentive Plan”), the number of AGL common shares that may be delivered under the Incentive Plan may not exceed 18,670,000. In the event of certain transactions affecting AGL's common shares, the number or type of shares subject to the Incentive Plan, the number and type of shares subject to outstanding awards under the Incentive Plan, and the exercise price of awards under the Incentive Plan, may be adjusted.
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The Incentive Plan authorizes the grant of incentive stock options, non-qualified stock options, stock appreciation rights, and full value awards that are based on AGL's common shares. The grant of full value awards may be in return for a participant's previously performed services, or in return for the participant surrendering other compensation that may be due, or may be contingent on the achievement of performance or other objectives during a specified period, or may be subject to a risk of forfeiture or other restrictions that will lapse upon the achievement of one or more goals relating to completion of service by the participant, or achievement of performance or other objectives. Awards under the Incentive Plan may accelerate and become vested upon a change in control of AGL.
The Incentive Plan is administered by a committee of the Board of Directors. The Compensation Committee of the Board serves as this committee except as otherwise determined by the Board. The Board may amend or terminate the Incentive Plan. As of December 31, 2014, 10,712,661 common shares were available for grant under the Incentive Plan.
Time Vested Stock Options
Nonqualified or incentive stock options may be granted to employees and directors of the Company. Stock options are generally granted once a year with exercise prices equal to the closing price on the date of grant. To date, the Company has only issued non-qualified stock options. All stock options, except for performance stock options, granted to employees vest in equal annual installments over a three-year period and expire seven years or ten years from the date of grant. Stock options granted to directors vest over one year and expire in seven years or ten years from grant date. None of the Company's options, except for performance stock options, have a performance or market condition.
Time Vested Stock Options
Options for Common Shares | Weighted Average Exercise Price | Weighted Average Grant Date Fair Value Per Share | Number of Exercisable Options | Year of Expiration | |||||||||||
Balance as of December 31, 2013 | 3,129,251 | $ | 20.97 | 2,987,088 | |||||||||||
Options granted | 83,162 | 21.88 | $ | 10.35 | 2021 | ||||||||||
Options exercised | (409,560 | ) | 17.88 | ||||||||||||
Options forfeited/expired | — | — | |||||||||||||
Balance as of December 31, 2014 | 2,802,853 | $ | 21.45 | 2,631,653 | |||||||||||
As of December 31, 2014, the aggregate intrinsic value and weighted average remaining contractual term of stock options outstanding were $13 million and 2.9 years, respectively. As of December 31, 2014, the aggregate intrinsic value and weighted average remaining contractual term of exercisable stock options were $12 million and 2.7 years, respectively.
As of December 31, 2014 the total unrecognized compensation expense related to outstanding nonvested stock options was $1 million, which will be adjusted in the future for the difference between estimated and actual forfeitures. The Company expects to recognize that expense over the weighted average remaining service period of 1.3 years.
Lattice Option Pricing
Weighted Average Assumptions
2014 | 2013 | 2012 | |||||||
Dividend yield | 2.03 | % | 2.07 | % | 2.06 | % | |||
Expected volatility | 53.24 | % | 53.41 | % | 58.89 | % | |||
Risk free interest rate | 2.21 | % | 1.35 | % | 1.45 | % | |||
Expected life | 6.6 years | 6.6 years | 6.6 years | ||||||
Forfeiture rate | 3.5 | % | 4.5 | % | 4.5 | % | |||
Weighted average grant date fair value | 10.35 | $ | 8.94 | 8.62 | |||||
The Company uses a lattice model to value its employee and director stock options, rather than a simple Black-Scholes-Merton (“Black-Scholes”) formula. The Black-Scholes approach is designed for options exercisable only at maturity (European style), but can still be used to value options exercisable at any time after they vest (“American style”) as long as no dividend payments are being made on the stock. A lattice model can be used for both European and American style options and
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regardless of whether or not the stock is paying regular dividends. Because the options the Company has granted to its employees and directors are American style and because the Company pays regular dividends on its stock, the Company has selected a lattice model as the appropriate method to value these options.
The expected dividend yield is based on the current expected annual dividend and share price on the grant date. The expected volatility is estimated at the date of grant based on an average of the 7-year historical share price volatility and implied volatilities of certain at-the-money actively traded call options in the Company. The risk-free interest rate is the implied 7-year yield currently available on U.S. Treasury zero-coupon issues at the date of grant. The forfeiture rate is based on the historical employee termination information.
The total intrinsic value of stock options exercised during the years ended December 31, 2014, 2013 and 2012 was $3.0 million, $7.5 million and $0.1 million, respectively. During the years ended December 31, 2014, 2013 and 2012, $4.3 million, $2.6 million and $44 thousand, respectively, was received from the exercise of stock options. In order to satisfy stock option exercises, the Company issues new shares.
Performance Stock Options
The Company grants performance stock options under the Incentive Plan. These awards are non-qualified stock options with exercise prices equal to the closing price an AGL common share on the applicable date of grant. These awards vest 35%, 50% or 100%, if the price of AGL's common shares using the highest 40-day average share price during the relevant performance period reaches certain hurdles. If the share price is between the specified levels, the vesting level will be interpolated accordingly. These awards expire seven years from the date of grant.
Performance Stock Options
Options for Common Shares | Weighted Average Exercise Price | Weighted Average Grant Date Fair Value Per Share | Number of Exercisable Options | Year of Expiration | ||||||||||||
Balance as of December 31, 2013 | 365,717 | $ | 17.80 | 0 | ||||||||||||
Options granted | — | — | $ | — | — | |||||||||||
Options exercised | — | — | ||||||||||||||
Options forfeited/expired | (118,838 | ) | 17.44 | |||||||||||||
Balance as of December 31, 2014 | 246,879 | $ | 17.97 | 0 | ||||||||||||
In order to satisfy stock option exercises, the Company issues new shares.
As of December 31, 2014, the aggregate intrinsic value and weighted average remaining contractual term of performance stock options outstanding were $2 million and 4.4 years, respectively. As of December 31, 2014, no performance options were exercisable.
As of December 31, 2014 the total unrecognized compensation expense related to outstanding nonvested performance stock options was $0.3 million, which will be adjusted in the future for the difference between estimated and actual forfeitures. The Company expects to recognize that expense over the weighted average remaining service period of 0.9 years.
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Monte Carlo and Lattice Option Pricing
Weighted Average Assumptions (1)
2013 | 2012 | ||||||
Dividend yield | 2.07 | % | 2.06 | % | |||
Expected volatility | 53.5 | % | 58.89 | % | |||
Risk free interest rate | 1.36 | % | 1.45 | % | |||
Expected life | 6.3 years | 6.3 years | |||||
Forfeiture rate | 4.5 | % | 4.5 | % | |||
Weighted average grant date fair value | $ | 8.17 | $ | 7.84 | |||
____________________
(1) | No options were granted in 2014. |
The expected dividend yield is based on the current expected annual dividend and share price on the grant date. The expected volatility is estimated at the date of grant based on an average of the 7-year historical share price volatility and implied volatilities of certain at-the-money actively traded call options in the Company. The risk-free interest rate is the implied 7-year yield currently available on U.S. Treasury zero-coupon issues at the date of grant. The forfeiture rate is based on the historical employee termination information.
Restricted Stock Awards
Restricted stock awards to employees generally vest in equal annual installments over a four-year period and restricted stock awards to outside directors vest in full in one year. Restricted stock awards are amortized on a straight-line basis over the requisite service periods of the awards, and restricted stock awards to outside directors are amortized over one year, which are generally the vesting periods, with the exception of retirement‑eligible employees, discussed above.
Restricted Stock Award Activity
Nonvested Shares | Number of Shares | Weighted Average Grant Date Fair Value Per Share | |||||
Nonvested at December 31, 2013 | 48,273 | $ | 23.20 | ||||
Granted | 47,747 | 23.98 | |||||
Vested | (48,273 | ) | 23.20 | ||||
Forfeited | (4,170 | ) | 23.98 | ||||
Nonvested at December 31, 2014 | 43,577 | $ | 23.98 | ||||
As of December 31, 2014 the total unrecognized compensation cost related to outstanding nonvested restricted stock awards was $0.4 million, which the Company expects to recognize over the weighted‑average remaining service period of 0.4 years. The total fair value of shares vested during the years ended December 31, 2014, 2013 and 2012 was $1 million, $1 million and $1 million, respectively.
Restricted Stock Units
Restricted stock units are valued based on the closing price of the underlying shares at the date of grant. Restricted stock units awarded to employees have vesting terms similar to those of the restricted stock awards and are delivered on the vesting date. The Company has granted restricted stock units to directors of the Company. Restricted stock units awarded to directors vest over a one-year period and are delivered after directors terminate from the board of directors.
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Restricted Stock Unit Activity
(Excluding Dividend Equivalents)
Nonvested Stock Units | Number of Stock Units | Weighted Average Grant Date Fair Value Per Share | |||||
Nonvested at December 31, 2013 | 736,409 | $ | 17.63 | ||||
Granted | 238,976 | 21.61 | |||||
Delivered | (284,082 | ) | 17.13 | ||||
Forfeited | — | — | |||||
Nonvested at December 31, 2014 | 691,303 | $ | 19.23 | ||||
As of December 31, 2014, the total unrecognized compensation cost related to outstanding nonvested restricted stock units was $5.2 million, which the Company expects to recognize over the weighted‑average remaining service period of 1.9 years. The total fair value of restricted stock units delivered during the years ended December 31, 2014, 2013 and 2012 was $5 million, $5 million and $6 million, respectively.
Performance Restricted Stock Units
Beginning in 2012, the Company has granted performance restricted stock units under the Incentive Plan. These awards vest 35%, 100%, or 200%, if the price of AGL's common shares using the highest 40-day average share price during the relevant performance period reaches certain hurdles. If the share price is between the specified levels, the vesting level will be interpolated accordingly.
Performance Restricted Stock Unit Activity
Performance Restricted Stock Units | Number of Performance Share Units | Weighted Average Grant Date Fair Value Per Share | |||||
Nonvested at December 31, 2013 | 223,410 | $ | 27.79 | ||||
Granted | 203,287 | 25.17 | |||||
Delivered | — | — | |||||
Forfeited | (3,395 | ) | 27.35 | ||||
Nonvested at December 31, 2014 | 423,302 | $ | 26.72 | ||||
As of December 31, 2014, the total unrecognized compensation cost related to outstanding nonvested performance share units was $3.7 million, which the Company expects to recognize over the weighted‑average remaining service period of 1.9 years.
Employee Stock Purchase Plan
The Company established the AGL Employee Stock Purchase Plan ("Stock Purchase Plan") in accordance with Internal Revenue Code Section 423, and participation is available to all eligible employees. Maximum annual purchases by participants are limited to the number of whole shares that can be purchased by an amount equal to 10% of the participant's compensation or, if less, shares having a value of $25,000. Participants may purchase shares at a purchase price equal to 85% of the lesser of the fair market value of the stock on the first day or the last day of the subscription period. The Company has reserved for issuance and purchases under the Stock Purchase Plan 600,000 Assured Guaranty Ltd. common shares.
The fair value of each award under the Stock Purchase Plan is estimated at the beginning of each offering period using the Black‑Scholes option‑pricing model and the following assumptions: a) the expected dividend yield is based on the current expected annual dividend and share price on the grant date; b) the expected volatility is estimated at the date of grant based on the historical share price volatility, calculated on a daily basis; c) the risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant; and d) the expected life is based on the term of the offering period.
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Stock Purchase Plan
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(dollars in millions) | |||||||||||
Proceeds from purchase of shares by employees | $ | 0.9 | $ | 0.9 | $ | 0.6 | |||||
Number of shares issued by the Company | 43,273 | 57,980 | 54,612 | ||||||||
Recorded in share-based compensation, after the effects of DAC | $ | 0.2 | $ | 0.3 | $ | 0.2 | |||||
Share‑Based Compensation Expense
The following table presents stock based compensation costs by type of award and the effect of deferring such costs as policy acquisition costs, pre-tax. Amortization of previously deferred stock compensation costs is not shown in the table below.
Share‑Based Compensation Expense Summary
Year Ended December 31, | |||||||||||
2014 | 2013 | 2012 | |||||||||
(in millions) | |||||||||||
Share‑Based Employee Cost: | |||||||||||
Recurring amortization | $ | 9 | $ | 7 | $ | 6 | |||||
Accelerated amortization for retirement eligible employees | 0 | — | 1 | ||||||||
Subtotal | 9 | 7 | 7 | ||||||||
ESPP | 0 | 0 | 0 | ||||||||
Total Share‑Based Employee Cost | 9 | 7 | 7 | ||||||||
Total Share‑Based Directors Cost | 1 | 1 | 1 | ||||||||
Total Share‑Based Cost | 10 | 8 | 8 | ||||||||
Less: Share‑based compensation capitalized as DAC | 0 | — | 1 | ||||||||
Share‑based compensation expense | $ | 10 | $ | 8 | $ | 7 | |||||
Income tax benefit | $ | 2 | $ | 2 | $ | 2 | |||||
Defined Contribution Plan
The Company maintains a savings incentive plan, which is qualified under Section 401(a) of the Internal Revenue Code for U.S. employees. The savings incentive plan is available to eligible full-time employees upon hire. Eligible participants could contribute a percentage of their salary subject to a maximum of $17,500 for 2014. Contributions are matched by the Company at a rate of 100% up to 6% of participant's compensation, subject to IRS limitations. Any amounts over the IRS limits are contributed to and matched by the Company into a nonqualified supplemental executive retirement plan for employees eligible to participate in such nonqualified plan. The Company also makes a core contribution of 6% of the participant's compensation to the qualified plan, subject to IRS limitations, and the nonqualified supplemental executive retirement plan for eligible employees, regardless of whether the employee contributes to the plan(s). Employees become fully vested in Company contributions after one year of service, as defined in the plan. Plan eligibility is immediate upon hire. The Company also maintains similar non-qualified plans for non-U.S. employees.
The Company recognized defined contribution expenses of $11 million, $10 million and $9 million for the years ended December 31, 2014, 2013 and 2012, respectively.
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Cash-Based Compensation
Performance Retention Plan
The Company has established the Assured Guaranty Ltd. Performance Retention Plan (“PRP”) which permits the grant of cash based awards to selected employees. PRP awards may be treated as nonqualified deferred compensation subject to the rules of Internal Revenue Code Section 409A. The PRP is a sub-plan under the Company's Long-Term Incentive Plan (enabling awards under the plan to be performance based compensation exempt from the $1 million limit on tax deductible compensation).
Generally, each PRP award is divided into three installments, with 25% of the award allocated to a performance period that includes the year of the award and the next year, 25% of the award allocated to a performance period that includes the year of the award and the next two years, and 50% of the award allocated to a performance period that includes the year of the award and the next three years. Each installment of an award vests if the participant remains employed through the end of the performance period for that installment. Awards may vest upon the occurrence of other events as set forth in the plan documents. Payment for each performance period is made at the end of that performance period. One half of each installment is increased or decreased in proportion to the increase or decrease of adjusted book value per share during the performance period, and one half of each installment is increased or decreased in proportion to the operating return on equity during the performance period. Operating return on equity and adjusted book value are defined in each PRP award agreement.
A payment otherwise subject to the $1 million limit on tax deductible compensation, will not be made unless performance satisfies a minimum threshold.
As described above, the performance measures used to determine the amounts distributable under the PRP are based on the Company's operating return on equity and growth in adjusted book value per share, as defined. Adjustments may be made by the AGL Compensation Committee at any time before distribution, except that, for certain senior executive officers, any adjustment made after the grant of the award may decrease but may not increase the amount of the distribution.
In the event of a corporate transaction involving the Company, including, without limitation, any share dividend, share split, extraordinary cash dividend, recapitalization, reorganization, merger, amalgamation, consolidation, split-up, spin-off, sale of assets or subsidiaries, combination or exchange of shares, the Compensation Committee may adjust the calculation of the Company's adjusted book value and operating return on equity as the Compensation Committee deems necessary or desirable in order to preserve the benefits or potential benefits of PRP awards.
The Company recognized performance retention plan expenses of $15 million, $17 million and $13 million for the years ended December 31, 2014, 2013 and 2012, respectively.
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21. | Other Comprehensive Income |
The following tables present the changes in each component of AOCI and the effect of significant reclassifications out of AOCI on the respective line items in net income.
Changes in Accumulated Other Comprehensive Income by Component
Year Ended December 31, 2014
Net Unrealized Gains (Losses) on Investments with no Other-Than-Temporary Impairment | Net Unrealized Gains (Losses) on Investments with Other-Than-Temporary Impairment | Cumulative Translation Adjustment | Cash Flow Hedge | Total Accumulated Other Comprehensive Income | |||||||||||||||
(in millions) | |||||||||||||||||||
Balance, December 31, 2013 | $ | 178 | $ | (24 | ) | $ | (3 | ) | $ | 9 | $ | 160 | |||||||
Other comprehensive income (loss) before reclassifications | 196 | (20 | ) | (7 | ) | — | 169 | ||||||||||||
Amounts reclassified from AOCI to: | |||||||||||||||||||
Net realized investment gains (losses) | (12 | ) | 74 | — | — | 62 | |||||||||||||
Interest expense | — | — | — | 0 | 0 | ||||||||||||||
Total before tax | (12 | ) | 74 | — | 0 | 62 | |||||||||||||
Tax (provision) benefit | 5 | (26 | ) | — | 0 | (21 | ) | ||||||||||||
Total amount reclassified from AOCI, net of tax | (7 | ) | 48 | — | 0 | 41 | |||||||||||||
Net current period other comprehensive income (loss) | 189 | 28 | (7 | ) | 0 | 210 | |||||||||||||
Balance, December 31, 2014 | $ | 367 | $ | 4 | $ | (10 | ) | $ | 9 | $ | 370 | ||||||||
Changes in Accumulated Other Comprehensive Income by Component
Year Ended December 31, 2013
Net Unrealized Gains (Losses) on Investments with no Other-Than-Temporary Impairment | Net Unrealized Gains (Losses) on Investments with Other-Than-Temporary Impairment | Cumulative Translation Adjustment | Cash Flow Hedge | Total Accumulated Other Comprehensive Income | |||||||||||||||
(in millions) | |||||||||||||||||||
Balance, December 31, 2012 | $ | 517 | $ | (5 | ) | $ | (6 | ) | $ | 9 | $ | 515 | |||||||
Other comprehensive income (loss) before reclassifications | (309 | ) | (35 | ) | 3 | — | (341 | ) | |||||||||||
Amounts reclassified from AOCI to: | |||||||||||||||||||
Net realized investment gains (losses) | (43 | ) | 24 | — | — | (19 | ) | ||||||||||||
Interest expense | — | — | — | (1 | ) | (1 | ) | ||||||||||||
Total before tax | (43 | ) | 24 | — | (1 | ) | (20 | ) | |||||||||||
Tax (provision) benefit | 13 | (8 | ) | — | 1 | 6 | |||||||||||||
Total amount reclassified from AOCI, net of tax | (30 | ) | 16 | — | 0 | (14 | ) | ||||||||||||
Net current period other comprehensive income (loss) | (339 | ) | (19 | ) | 3 | 0 | (355 | ) | |||||||||||
Balance, December 31, 2013 | $ | 178 | $ | (24 | ) | $ | (3 | ) | $ | 9 | $ | 160 | |||||||
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Changes in Accumulated Other Comprehensive Income by Component
Year Ended December 31, 2012
Net Unrealized Gains (Losses) on Investments with no Other-Than-Temporary Impairment | Net Unrealized Gains (Losses) on Investments with Other-Than-Temporary Impairment | Cumulative Translation Adjustment | Cash Flow Hedge | Total Accumulated Other Comprehensive Income | |||||||||||||||
(in millions) | |||||||||||||||||||
Balance, December 31, 2011 | $ | 365 | $ | 2 | $ | (8 | ) | $ | 9 | $ | 368 | ||||||||
Other comprehensive income (loss) | 152 | (7 | ) | 2 | 0 | 147 | |||||||||||||
Balance, December 31, 2012 | $ | 517 | $ | (5 | ) | $ | (6 | ) | $ | 9 | $ | 515 | |||||||
22. | Subsidiary Information |
The following tables present the condensed consolidating financial information for AGUS and AGMH, wholly-owned subsidiaries of AGL, which have issued publicly traded debt securities (see Note 17, Long-Term Debt and Credit Facilities, for the full description of AGUS and AGMH debt and the related AGL guarantees for such debt) as of December 31, 2014 and December 31, 2013 and for the years ended December 31, 2014, 2013 and 2012. The information for AGUS and AGMH presents its subsidiaries on the equity method of accounting.
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CONDENSED CONSOLIDATING BALANCE SHEET
AS OF DECEMBER 31, 2014
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
ASSETS | |||||||||||||||||||||||
Total investment portfolio and cash | $ | 126 | $ | 204 | $ | 47 | $ | 11,382 | $ | (300 | ) | $ | 11,459 | ||||||||||
Investment in subsidiaries | 5,612 | 5,072 | 3,965 | 339 | (14,988 | ) | — | ||||||||||||||||
Premiums receivable, net of commissions payable | — | — | — | 864 | (135 | ) | 729 | ||||||||||||||||
Ceded unearned premium reserve | — | — | — | 1,469 | (1,088 | ) | 381 | ||||||||||||||||
Deferred acquisition costs | — | — | — | 186 | (65 | ) | 121 | ||||||||||||||||
Reinsurance recoverable on unpaid losses | — | — | — | 338 | (260 | ) | 78 | ||||||||||||||||
Credit derivative assets | — | — | — | 277 | (209 | ) | 68 | ||||||||||||||||
Deferred tax asset, net | — | 54 | — | 295 | (89 | ) | 260 | ||||||||||||||||
Intercompany receivable | — | — | — | 90 | (90 | ) | — | ||||||||||||||||
Financial guaranty variable interest entities’ assets, at fair value | — | — | — | 1,402 | — | 1,402 | |||||||||||||||||
Other | 27 | 77 | 27 | 538 | (242 | ) | 427 | ||||||||||||||||
TOTAL ASSETS | $ | 5,765 | $ | 5,407 | $ | 4,039 | $ | 17,180 | $ | (17,466 | ) | $ | 14,925 | ||||||||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | |||||||||||||||||||||||
Unearned premium reserves | $ | — | $ | — | $ | — | $ | 5,328 | $ | (1,067 | ) | $ | 4,261 | ||||||||||
Loss and LAE reserve | — | — | — | 1,066 | (267 | ) | 799 | ||||||||||||||||
Long-term debt | — | 847 | 437 | 19 | — | 1,303 | |||||||||||||||||
Intercompany payable | — | 90 | — | 300 | (390 | ) | — | ||||||||||||||||
Credit derivative liabilities | — | — | — | 1,172 | (209 | ) | 963 | ||||||||||||||||
Deferred tax liabilities, net | — | — | 94 | — | (94 | ) | — | ||||||||||||||||
Financial guaranty variable interest entities’ liabilities, at fair value | — | — | — | 1,419 | — | 1,419 | |||||||||||||||||
Other | 7 | 9 | 16 | 764 | (374 | ) | 422 | ||||||||||||||||
TOTAL LIABILITIES | 7 | 946 | 547 | 10,068 | (2,401 | ) | 9,167 | ||||||||||||||||
TOTAL SHAREHOLDERS’ EQUITY ATTRIBUTABLE TO ASSURED GUARANTY LTD. | 5,758 | 4,461 | 3,492 | 6,773 | (14,726 | ) | 5,758 | ||||||||||||||||
Noncontrolling interest | — | — | — | 339 | (339 | ) | — | ||||||||||||||||
TOTAL SHAREHOLDERS’ EQUITY | 5,758 | 4,461 | 3,492 | 7,112 | (15,065 | ) | 5,758 | ||||||||||||||||
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY | $ | 5,765 | $ | 5,407 | $ | 4,039 | $ | 17,180 | $ | (17,466 | ) | $ | 14,925 | ||||||||||
261
CONDENSED CONSOLIDATING BALANCE SHEET
AS OF DECEMBER 31, 2013
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
ASSETS | |||||||||||||||||||||||
Total investment portfolio and cash | $ | 33 | $ | 186 | $ | 42 | $ | 11,008 | $ | (300 | ) | $ | 10,969 | ||||||||||
Investment in subsidiaries | 5,066 | 4,191 | 3,574 | 289 | (13,120 | ) | — | ||||||||||||||||
Premiums receivable, net of commissions payable | — | — | — | 1,025 | (149 | ) | 876 | ||||||||||||||||
Ceded unearned premium reserve | — | — | — | 1,598 | (1,146 | ) | 452 | ||||||||||||||||
Deferred acquisition costs | — | — | — | 198 | (74 | ) | 124 | ||||||||||||||||
Reinsurance recoverable on unpaid losses | — | — | — | 170 | (134 | ) | 36 | ||||||||||||||||
Credit derivative assets | — | — | — | 482 | (388 | ) | 94 | ||||||||||||||||
Deferred tax asset, net | — | 97 | — | 681 | (90 | ) | 688 | ||||||||||||||||
Intercompany receivable | — | — | — | 90 | (90 | ) | — | ||||||||||||||||
Financial guaranty variable interest entities’ assets, at fair value | — | — | — | 2,565 | — | 2,565 | |||||||||||||||||
Other | 23 | 17 | 31 | 638 | (226 | ) | 483 | ||||||||||||||||
TOTAL ASSETS | $ | 5,122 | $ | 4,491 | $ | 3,647 | $ | 18,744 | $ | (15,717 | ) | $ | 16,287 | ||||||||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | |||||||||||||||||||||||
Unearned premium reserves | $ | — | $ | — | $ | — | $ | 5,720 | $ | (1,125 | ) | $ | 4,595 | ||||||||||
Loss and LAE reserve | — | — | — | 733 | (141 | ) | 592 | ||||||||||||||||
Long-term debt | — | 348 | 430 | 38 | — | 816 | |||||||||||||||||
Intercompany payable | — | 90 | — | 300 | (390 | ) | — | ||||||||||||||||
Credit derivative liabilities | — | — | — | 2,175 | (388 | ) | 1,787 | ||||||||||||||||
Deferred tax liabilities, net | — | — | 95 | — | (95 | ) | — | ||||||||||||||||
Financial guaranty variable interest entities’ liabilities, at fair value | — | — | — | 2,871 | — | 2,871 | |||||||||||||||||
Other | 7 | 7 | 16 | 853 | (372 | ) | 511 | ||||||||||||||||
TOTAL LIABILITIES | 7 | 445 | 541 | 12,690 | (2,511 | ) | 11,172 | ||||||||||||||||
TOTAL SHAREHOLDERS’ EQUITY ATTRIBUTABLE TO ASSURED GUARANTY LTD. | 5,115 | 4,046 | 3,106 | 5,765 | (12,917 | ) | 5,115 | ||||||||||||||||
Noncontrolling interest | — | — | — | 289 | (289 | ) | — | ||||||||||||||||
TOTAL SHAREHOLDERS’ EQUITY | 5,115 | 4,046 | 3,106 | 6,054 | (13,206 | ) | 5,115 | ||||||||||||||||
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY | $ | 5,122 | $ | 4,491 | $ | 3,647 | $ | 18,744 | $ | (15,717 | ) | $ | 16,287 | ||||||||||
262
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
AND COMPREHENSIVE INCOME
FOR THE YEAR ENDED DECEMBER 31, 2014
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
REVENUES | |||||||||||||||||||||||
Net earned premiums | $ | — | $ | — | $ | — | $ | 566 | $ | 4 | $ | 570 | |||||||||||
Net investment income | 0 | 0 | 1 | 412 | (10 | ) | 403 | ||||||||||||||||
Net realized investment gains (losses) | 0 | 0 | 0 | (58 | ) | (2 | ) | (60 | ) | ||||||||||||||
Net change in fair value of credit derivatives: | |||||||||||||||||||||||
Realized gains (losses) and other settlements | — | — | — | 23 | — | 23 | |||||||||||||||||
Net unrealized gains (losses) | — | — | — | 800 | — | 800 | |||||||||||||||||
Net change in fair value of credit derivatives | — | — | — | 823 | — | 823 | |||||||||||||||||
Other | 0 | 0 | — | 259 | (1 | ) | 258 | ||||||||||||||||
TOTAL REVENUES | 0 | 0 | 1 | 2,002 | (9 | ) | 1,994 | ||||||||||||||||
EXPENSES | |||||||||||||||||||||||
Loss and LAE | — | — | — | 122 | 4 | 126 | |||||||||||||||||
Amortization of deferred acquisition costs | — | — | — | 33 | (8 | ) | 25 | ||||||||||||||||
Interest expense | — | 40 | 54 | 16 | (18 | ) | 92 | ||||||||||||||||
Other operating expenses | 31 | 1 | 1 | 195 | (8 | ) | 220 | ||||||||||||||||
TOTAL EXPENSES | 31 | 41 | 55 | 366 | (30 | ) | 463 | ||||||||||||||||
INCOME (LOSS) BEFORE INCOME TAXES AND EQUITY IN NET EARNINGS OF SUBSIDIARIES | (31 | ) | (41 | ) | (54 | ) | 1,636 | 21 | 1,531 | ||||||||||||||
Total (provision) benefit for income taxes | — | 14 | 19 | (469 | ) | (7 | ) | (443 | ) | ||||||||||||||
Equity in net earnings of subsidiaries | $ | 1,119 | $ | 983 | $ | 513 | $ | 32 | $ | (2,647 | ) | — | |||||||||||
NET INCOME (LOSS) | 1,088 | 956 | 478 | 1,199 | (2,633 | ) | 1,088 | ||||||||||||||||
Less: noncontrolling interest | — | — | — | 32 | (32 | ) | — | ||||||||||||||||
NET INCOME (LOSS) ATTRIBUTABLE TO ASSURED GUARANTY LTD. | $ | 1,088 | $ | 956 | $ | 478 | $ | 1,167 | $ | (2,601 | ) | $ | 1,088 | ||||||||||
COMPREHENSIVE INCOME (LOSS) | $ | 1,298 | $ | 1,114 | $ | 577 | $ | 1,570 | $ | (3,261 | ) | $ | 1,298 | ||||||||||
263
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
AND COMPREHENSIVE INCOME
FOR THE YEAR ENDED DECEMBER 31, 2013
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
REVENUES | |||||||||||||||||||||||
Net earned premiums | $ | — | $ | — | $ | — | $ | 740 | $ | 12 | $ | 752 | |||||||||||
Net investment income | 0 | 0 | 1 | 408 | (16 | ) | 393 | ||||||||||||||||
Net realized investment gains (losses) | 0 | 0 | 0 | 87 | (35 | ) | 52 | ||||||||||||||||
Net change in fair value of credit derivatives: | |||||||||||||||||||||||
Realized gains (losses) and other settlements | — | — | — | (42 | ) | — | (42 | ) | |||||||||||||||
Net unrealized gains (losses) | — | — | — | 107 | — | 107 | |||||||||||||||||
Net change in fair value of credit derivatives | — | — | — | 65 | — | 65 | |||||||||||||||||
Other | — | — | — | 348 | (2 | ) | 346 | ||||||||||||||||
TOTAL REVENUES | 0 | 0 | 1 | 1,648 | (41 | ) | 1,608 | ||||||||||||||||
EXPENSES | |||||||||||||||||||||||
Loss and LAE | — | — | — | 144 | 10 | 154 | |||||||||||||||||
Amortization of deferred acquisition costs | — | — | — | 12 | 0 | 12 | |||||||||||||||||
Interest expense | — | 28 | 54 | 20 | (20 | ) | 82 | ||||||||||||||||
Other operating expenses | 22 | 1 | 1 | 199 | (5 | ) | 218 | ||||||||||||||||
TOTAL EXPENSES | 22 | 29 | 55 | 375 | (15 | ) | 466 | ||||||||||||||||
INCOME (LOSS) BEFORE INCOME TAXES AND EQUITY IN NET EARNINGS OF SUBSIDIARIES | (22 | ) | (29 | ) | (54 | ) | 1,273 | (26 | ) | 1,142 | |||||||||||||
Total (provision) benefit for income taxes | — | 9 | 17 | (387 | ) | 27 | (334 | ) | |||||||||||||||
Equity in net earnings of subsidiaries | 830 | 768 | 701 | 19 | (2,318 | ) | — | ||||||||||||||||
NET INCOME (LOSS) | 808 | 748 | 664 | 905 | (2,317 | ) | 808 | ||||||||||||||||
Less: noncontrolling interest | — | — | — | 19 | (19 | ) | — | ||||||||||||||||
NET INCOME (LOSS) ATTRIBUTABLE TO ASSURED GUARANTY LTD. | $ | 808 | $ | 748 | $ | 664 | $ | 886 | $ | (2,298 | ) | $ | 808 | ||||||||||
COMPREHENSIVE INCOME (LOSS) | $ | 453 | $ | 522 | $ | 515 | $ | 309 | $ | (1,346 | ) | $ | 453 | ||||||||||
264
CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS
AND COMPREHENSIVE INCOME
FOR THE YEAR ENDED DECEMBER 31, 2012
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
REVENUES | |||||||||||||||||||||||
Net earned premiums | $ | — | $ | — | $ | — | $ | 833 | $ | 20 | $ | 853 | |||||||||||
Net investment income | 0 | — | 1 | 422 | (19 | ) | 404 | ||||||||||||||||
Net realized investment gains (losses) | — | — | — | 1 | — | 1 | |||||||||||||||||
Net change in fair value of credit derivatives: | |||||||||||||||||||||||
Realized gains (losses) and other settlements | — | — | — | (108 | ) | — | (108 | ) | |||||||||||||||
Net unrealized gains (losses) | — | — | — | (477 | ) | — | (477 | ) | |||||||||||||||
Net change in fair value of credit derivatives | — | — | — | (585 | ) | — | (585 | ) | |||||||||||||||
Other | — | — | — | 284 | (3 | ) | 281 | ||||||||||||||||
TOTAL REVENUES | 0 | — | 1 | 955 | (2 | ) | 954 | ||||||||||||||||
EXPENSES | |||||||||||||||||||||||
Loss and LAE | — | — | — | 509 | (5 | ) | 504 | ||||||||||||||||
Amortization of deferred acquisition costs | — | — | — | 28 | (14 | ) | 14 | ||||||||||||||||
Interest expense | — | 35 | 54 | 22 | (19 | ) | 92 | ||||||||||||||||
Other operating expenses | 21 | 2 | 1 | 194 | (6 | ) | 212 | ||||||||||||||||
TOTAL EXPENSES | 21 | 37 | 55 | 753 | (44 | ) | 822 | ||||||||||||||||
INCOME (LOSS) BEFORE INCOME TAXES AND EQUITY IN NET EARNINGS OF SUBSIDIARIES | (21 | ) | (37 | ) | (54 | ) | 202 | 42 | 132 | ||||||||||||||
Total (provision) benefit for income taxes | — | 13 | 19 | (38 | ) | (16 | ) | (22 | ) | ||||||||||||||
Equity in net earnings of subsidiaries | 131 | 177 | 424 | 153 | (885 | ) | — | ||||||||||||||||
NET INCOME (LOSS) | $ | 110 | $ | 153 | $ | 389 | $ | 317 | $ | (859 | ) | $ | 110 | ||||||||||
COMPREHENSIVE INCOME (LOSS) | $ | 257 | $ | 266 | $ | 465 | $ | 577 | $ | (1,308 | ) | $ | 257 | ||||||||||
265
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2014
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
Net cash flows provided by (used in) operating activities | $ | 758 | $ | 223 | $ | 144 | $ | 663 | $ | (1,211 | ) | $ | 577 | ||||||||||
Cash flows from investing activities | |||||||||||||||||||||||
Fixed-maturity securities: | |||||||||||||||||||||||
Purchases | — | (540 | ) | (8 | ) | (2,253 | ) | — | (2,801 | ) | |||||||||||||
Sales | — | 464 | 10 | 777 | — | 1,251 | |||||||||||||||||
Maturities | — | 6 | 1 | 870 | — | 877 | |||||||||||||||||
Sales (purchases) of short-term investments, net | (93 | ) | (15 | ) | (3 | ) | 269 | — | 158 | ||||||||||||||
Net proceeds from financial guaranty variable entities’ assets | 408 | — | 408 | ||||||||||||||||||||
Intercompany debt | — | — | — | — | — | — | |||||||||||||||||
Investment in subsidiary | — | — | 50 | — | (50 | ) | — | ||||||||||||||||
Other | — | — | — | 11 | — | 11 | |||||||||||||||||
Net cash flows provided by (used in) investing activities | (93 | ) | (85 | ) | 50 | 82 | (50 | ) | (96 | ) | |||||||||||||
Cash flows from financing activities | |||||||||||||||||||||||
Return of capital | — | — | — | (50 | ) | 50 | — | ||||||||||||||||
Capital contribution from parent | — | — | — | — | — | — | |||||||||||||||||
Dividends paid | (76 | ) | (700 | ) | (190 | ) | (321 | ) | 1,211 | (76 | ) | ||||||||||||
Repurchases of common stock | (590 | ) | — | — | — | — | (590 | ) | |||||||||||||||
Share activity under option and incentive plans | 1 | — | — | — | — | 1 | |||||||||||||||||
Net paydowns of financial guaranty variable entities’ liabilities | — | — | — | (396 | ) | — | (396 | ) | |||||||||||||||
Net proceeds from issuance of long-term debt | — | 495 | — | — | — | 495 | |||||||||||||||||
Payment of long-term debt | — | — | — | (19 | ) | — | (19 | ) | |||||||||||||||
Intercompany debt | — | — | — | — | — | — | |||||||||||||||||
Net cash flows provided by (used in) financing activities | (665 | ) | (205 | ) | (190 | ) | (786 | ) | 1,261 | (585 | ) | ||||||||||||
Effect of exchange rate changes | — | — | — | (5 | ) | — | (5 | ) | |||||||||||||||
Increase (decrease) in cash | — | (67 | ) | 4 | (46 | ) | — | (109 | ) | ||||||||||||||
Cash at beginning of period | 0 | 67 | 0 | 117 | — | 184 | |||||||||||||||||
Cash at end of period | $ | 0 | $ | 0 | $ | 4 | $ | 71 | $ | — | $ | 75 | |||||||||||
266
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2013
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
Net cash flows provided by (used in) operating activities | $ | 128 | $ | 178 | $ | 133 | $ | 347 | $ | (542 | ) | $ | 244 | ||||||||||
Cash flows from investing activities | |||||||||||||||||||||||
Fixed-maturity securities: | |||||||||||||||||||||||
Purchases | — | (93 | ) | (26 | ) | (1,832 | ) | 65 | (1,886 | ) | |||||||||||||
Sales | 176 | 1 | 25 | 892 | (65 | ) | 1,029 | ||||||||||||||||
Maturities | 29 | 3 | 2 | 849 | — | 883 | |||||||||||||||||
Sales (purchases) of short-term investments, net | 7 | (28 | ) | (15 | ) | (51 | ) | — | (87 | ) | |||||||||||||
Net proceeds from financial guaranty variable entities’ assets | — | — | — | 663 | — | 663 | |||||||||||||||||
Intercompany debt | — | — | — | 7 | (7 | ) | — | ||||||||||||||||
Investment in subsidiary | — | 0 | 49 | — | (49 | ) | — | ||||||||||||||||
Other | — | — | — | 79 | — | 79 | |||||||||||||||||
Net cash flows provided by (used in) investing activities | 212 | (117 | ) | 35 | 607 | (56 | ) | 681 | |||||||||||||||
Cash flows from financing activities | — | ||||||||||||||||||||||
Return of capital | — | — | — | (50 | ) | 50 | — | ||||||||||||||||
Capital contribution from parent | — | — | — | 1 | (1 | ) | — | ||||||||||||||||
Dividends paid | (75 | ) | — | (168 | ) | (374 | ) | 542 | (75 | ) | |||||||||||||
Repurchases of common stock | (264 | ) | — | — | — | — | (264 | ) | |||||||||||||||
Share activity under option and incentive plans | (1 | ) | — | — | — | — | (1 | ) | |||||||||||||||
Net paydowns of financial guaranty variable entities’ liabilities | — | — | — | (511 | ) | — | (511 | ) | |||||||||||||||
Payment of long-term debt | — | — | — | (27 | ) | — | (27 | ) | |||||||||||||||
Intercompany debt | — | (7 | ) | — | — | 7 | — | ||||||||||||||||
Net cash flows provided by (used in) financing activities | (340 | ) | (7 | ) | (168 | ) | (961 | ) | 598 | (878 | ) | ||||||||||||
Effect of exchange rate changes | — | — | — | (1 | ) | — | (1 | ) | |||||||||||||||
Increase (decrease) in cash | 0 | 54 | — | (8 | ) | — | 46 | ||||||||||||||||
Cash at beginning of period | — | 13 | 0 | 125 | — | 138 | |||||||||||||||||
Cash at end of period | $ | 0 | $ | 67 | $ | 0 | $ | 117 | $ | — | $ | 184 | |||||||||||
267
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2012
(in millions)
Assured Guaranty Ltd. (Parent) | AGUS (Issuer) | AGMH (Issuer) | Other Entities | Consolidating Adjustments | Assured Guaranty Ltd. (Consolidated) | ||||||||||||||||||
Net cash flows provided by (used in) operating activities | $ | 138 | $ | 6 | $ | 20 | $ | 5 | $ | (334 | ) | $ | (165 | ) | |||||||||
Cash flows from investing activities | |||||||||||||||||||||||
Fixed-maturity securities: | |||||||||||||||||||||||
Purchases | (211 | ) | (1 | ) | (13 | ) | (1,424 | ) | — | (1,649 | ) | ||||||||||||
Sales | — | — | 13 | 899 | — | 912 | |||||||||||||||||
Maturities | 3 | — | 6 | 1,096 | — | 1,105 | |||||||||||||||||
Sales (purchases) of short-term investments, net | (7 | ) | 27 | 26 | (17 | ) | — | 29 | |||||||||||||||
Net proceeds from financial guaranty variable entities’ assets | — | — | — | 545 | — | 545 | |||||||||||||||||
Acquisition of MAC | — | (91 | ) | — | — | — | (91 | ) | |||||||||||||||
Intercompany debt | — | — | — | (173 | ) | 173 | — | ||||||||||||||||
Investment in subsidiary | — | — | 46 | — | (46 | ) | — | ||||||||||||||||
Other | — | — | — | 92 | — | 92 | |||||||||||||||||
Net cash flows provided by (used in) investing activities | (215 | ) | (65 | ) | 78 | 1,018 | 127 | 943 | |||||||||||||||
Cash flows from financing activities | |||||||||||||||||||||||
Issuance of common stock | 173 | — | — | — | — | 173 | |||||||||||||||||
Return of capital | — | — | — | (50 | ) | 50 | — | ||||||||||||||||
Capital contribution from parent | — | — | — | 4 | (4 | ) | — | ||||||||||||||||
Dividends paid | (69 | ) | — | (98 | ) | (236 | ) | 334 | (69 | ) | |||||||||||||
Repurchases of common stock | (24 | ) | — | — | — | — | (24 | ) | |||||||||||||||
Share activity under option and incentive plans | (3 | ) | — | — | — | — | (3 | ) | |||||||||||||||
Net paydowns of financial guaranty variable entities’ liabilities | — | — | — | (724 | ) | — | (724 | ) | |||||||||||||||
Payment of long-term debt | — | (173 | ) | — | (36 | ) | — | (209 | ) | ||||||||||||||
Intercompany debt | — | 173 | — | — | (173 | ) | — | ||||||||||||||||
Net cash flows provided by (used in) financing activities | 77 | — | (98 | ) | (1,042 | ) | 207 | (856 | ) | ||||||||||||||
Effect of exchange rate changes | — | — | — | 1 | — | 1 | |||||||||||||||||
Increase (decrease) in cash | — | (59 | ) | — | (18 | ) | — | (77 | ) | ||||||||||||||
Cash at beginning of period | — | 72 | 0 | 143 | — | 215 | |||||||||||||||||
Cash at end of period | $ | — | $ | 13 | $ | 0 | $ | 125 | $ | — | $ | 138 | |||||||||||
268
23. Quarterly Financial Information (Unaudited)
A summary of selected quarterly information follows:
2014 | First Quarter | Second Quarter | Third Quarter | Fourth Quarter | Full Year | |||||||||||||||
(dollars in millions, except per share data) | ||||||||||||||||||||
Revenues | ||||||||||||||||||||
Net earned premiums | $ | 132 | $ | 136 | $ | 144 | $ | 158 | $ | 570 | ||||||||||
Net investment income | 103 | 96 | 102 | 102 | 403 | |||||||||||||||
Net realized investment gains (losses) | 2 | (8 | ) | (19 | ) | (35 | ) | (60 | ) | |||||||||||
Net change in fair value of credit derivatives | (211 | ) | 103 | 255 | 676 | 823 | ||||||||||||||
Fair value gains (losses) on CCS | (9 | ) | (6 | ) | 4 | 0 | (11 | ) | ||||||||||||
Fair value gains (losses) on FG VIEs | 157 | 25 | 50 | 23 | 255 | |||||||||||||||
Other income (loss) | 21 | 7 | (11 | ) | (3 | ) | 14 | |||||||||||||
Expenses | ||||||||||||||||||||
Loss and LAE | 41 | 57 | (44 | ) | 72 | 126 | ||||||||||||||
Amortization of DAC | 5 | 3 | 4 | 13 | 25 | |||||||||||||||
Interest expense | 20 | 20 | 27 | 25 | 92 | |||||||||||||||
Other operating expenses | 60 | 55 | 50 | 55 | 220 | |||||||||||||||
Income (loss) before provision for income taxes | 69 | 218 | 488 | 756 | 1,531 | |||||||||||||||
Provision (benefit) for income taxes | 27 | 59 | 133 | 224 | 443 | |||||||||||||||
Net income (loss) | 42 | 159 | 355 | 532 | 1,088 | |||||||||||||||
Earnings (loss) per share(1): | ||||||||||||||||||||
Basic | $ | 0.23 | $ | 0.89 | $ | 2.10 | $ | 3.30 | $ | 6.30 | ||||||||||
Diluted | $ | 0.23 | $ | 0.89 | $ | 2.09 | $ | 3.28 | $ | 6.26 | ||||||||||
Dividends per share | $ | 0.11 | $ | 0.11 | $ | 0.11 | $ | 0.11 | $ | 0.44 | ||||||||||
269
2013 | First Quarter | Second Quarter | Third Quarter | Fourth Quarter | Full Year | |||||||||||||||
(dollars in millions, except per share data) | ||||||||||||||||||||
Revenues | ||||||||||||||||||||
Net earned premiums | $ | 248 | $ | 163 | $ | 159 | $ | 182 | $ | 752 | ||||||||||
Net investment income | 94 | 93 | 99 | 107 | 393 | |||||||||||||||
Net realized investment gains (losses) | 28 | 2 | (7 | ) | 29 | 52 | ||||||||||||||
Net change in fair value of credit derivatives | (592 | ) | 74 | 354 | 229 | 65 | ||||||||||||||
Fair value gains (losses) on CCS | (10 | ) | (3 | ) | 9 | 14 | 10 | |||||||||||||
Fair value gains (losses) on FG VIEs | 70 | 143 | 40 | 93 | 346 | |||||||||||||||
Other income (loss) | (14 | ) | (7 | ) | 16 | (5 | ) | (10 | ) | |||||||||||
Expenses | ||||||||||||||||||||
Loss and LAE | (48 | ) | 62 | 55 | 85 | 154 | ||||||||||||||
Amortization of DAC | 3 | 1 | 4 | 4 | 12 | |||||||||||||||
Interest expense | 21 | 21 | 21 | 19 | 82 | |||||||||||||||
Other operating expenses | 60 | 52 | 54 | 52 | 218 | |||||||||||||||
Income (loss) before provision for income taxes | (212 | ) | 329 | 536 | 489 | 1,142 | ||||||||||||||
Provision (benefit) for income taxes | (68 | ) | 110 | 152 | 140 | 334 | ||||||||||||||
Net income (loss) | (144 | ) | 219 | 384 | 349 | 808 | ||||||||||||||
Earnings (loss) per share(1): | ||||||||||||||||||||
Basic | $ | (0.74 | ) | $ | 1.17 | $ | 2.10 | $ | 1.91 | $ | 4.32 | |||||||||
Diluted | $ | (0.74 | ) | $ | 1.16 | $ | 2.09 | $ | 1.90 | $ | 4.30 | |||||||||
Dividends per share | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.10 | $ | 0.40 | ||||||||||
____________________
(1) | Per share amounts for the quarters and the full years have each been calculated separately. Accordingly, quarterly amounts may not sum up to the annual amounts because of differences in the average common shares outstanding during each period and, with regard to diluted per share amounts only, because of the inclusion of the effect of potentially dilutive securities only in the periods in which such effect would have been dilutive. |
ITEM 9. | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE |
None.
ITEM 9A. | CONTROLS AND PROCEDURES |
Disclosure Controls and Procedures
Assured Guaranty's management, with the participation of Assured Guaranty Ltd.'s President and Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of Assured Guaranty Ltd.'s disclosure controls and procedures (as such term is defined in Rules 13a 15(e) and 15d 15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on this evaluation, Assured Guaranty Ltd.'s President and Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Assured Guaranty Ltd.'s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Assured Guaranty Ltd. (including its consolidated subsidiaries) in the reports that it files or submits under the Exchange Act.
There has been no change in the Company's internal controls over financial reporting during the Company's quarter ended December 31, 2014, that has materially affected, or is reasonably likely to materially affect, the Company's internal controls over financial reporting.
270
Management's Report on Internal Control over Financial Reporting
The management of Assured Guaranty Ltd. is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). Internal control over financial reporting is a process designed by, or under the supervision of the Company's President and Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company's consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management of the Company has assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2014 using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in the 2013 Internal Control-Integrated Framework. Based on this evaluation, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2014 based on criteria in the 2013 Internal Control- Integrated Framework issued by the COSO.
The effectiveness of the Company's internal control over financial reporting as of December 31, 2014 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their "Report of Independent Registered Public Accounting Firm" included in Item 8. Financial Statements and Supplementary Data.
ITEM 9B. | OTHER INFORMATION |
None.
271
PART III
ITEM 10. | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE |
Information pertaining to this item is incorporated by reference to the sections entitled “Proposal No. 1: Election of Directors”, “Corporate Governance—Did our insiders comply with Section 16(a) beneficial ownership reporting in 2014”, “Corporate Governance—How are directors nominated?” and “Corporate Governance—The committees of the Board—The Audit Committee” of the definitive proxy statement for the Annual General Meeting of Shareholders, which involves the election of directors and will be filed with the SEC not later than 120 days after the close of the fiscal year pursuant to regulation 14A.
Information about the executive officers of AGL is set forth at the end of Part I of this Form 10-K and is hereby incorporated by reference.
Code of Conduct
The Company has adopted a Code of Conduct, which sets forth standards by which all employees, officers and directors of the Company must abide as they work for the Company. The Code of Conduct is available at www.assuredguaranty.com/governance. The Company intends to disclose on its internet site any amendments to, or waivers from, its Code of Conduct that are required to be publicly disclosed pursuant to the rules of the SEC or the New York Stock Exchange.
ITEM 11. | EXECUTIVE COMPENSATION |
This item is incorporated by reference to the sections entitled “Executive Compensation”, “Corporate Governance—Compensation Committee interlocking and insider participation” and “Corporate Governance—How are the directors compensated?” of the definitive proxy statement for the Annual General Meeting of Shareholders, which will be filed with the SEC not later than 120 days after the close of the fiscal year pursuant to regulation 14A.
ITEM 12. | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS |
This item is incorporated by reference to the sections entitled "Information about our Common Share Ownership" and "Equity Compensation Plans Information" of the definitive proxy statement for the Annual General Meeting of Shareholders, which will be filed with the SEC not later than 120 days after the close of the fiscal year pursuant to regulation 14A.
ITEM 13. | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE |
This item is incorporated by reference to the sections entitled “Corporate Governance—What is our related person transactions approval policy and what procedures do we use to implement it?”, “Corporate Governance—What related person transactions do we have?” and “Corporate Governance—Director independence” of the definitive proxy statement for the Annual General Meeting of Shareholders, which will be filed with the SEC not later than 120 days after the close of the fiscal year pursuant to regulation 14A.
ITEM 14. | PRINCIPAL ACCOUNTING FEES AND SERVICES |
This item is incorporated by reference to the section entitled “Proposal No. 3: Ratification of Appointment of Independent Auditors—Independent Auditor Fee Information” and “Proposal No. 3: Ratification of Appointment of Independent Auditors—Pre-Approval Policy of Audit and Non-Audit Services” of the definitive proxy statement for the Annual General Meeting of Shareholders, which will be filed with the SEC not later than 120 days after the close of the fiscal year pursuant to regulation 14A.
272
PART IV
ITEM 15. | EXHIBITS, FINANCIAL STATEMENT SCHEDULES |
(a) | Financial Statements, Financial Statement Schedules and Exhibits |
1. | Financial Statements |
The following financial statements of Assured Guaranty Ltd. have been included in Item 8 hereof:
2. Financial Statement Schedules
The financial statement schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto.
3. Exhibits*
Exhibit Number | Description of Document |
3.1 | Certificate of Incorporation and Memorandum of Association of the Registrant, as amended by Certificate of Incorporation on Change of Name dated March 30, 2004 and Certificate of Deposit of Memorandum of Increase of Capital dated April 21, 2004 (Incorporated by reference to Exhibit 3.1 to Form 10-K for the year ended December 31, 2009) |
3.2 | First Amended and Restated Bye-laws of the Registrant, as amended (Incorporated by reference to Exhibit 3.1 to Form 8-K filed on May 10, 2011) |
4.1 | Specimen Common Share Certificate (Incorporated by reference to Exhibit 4.1 to Form S-1 (#333-111491)) |
4.2 | Certificate of Incorporation and Memorandum of Association of the Registrant, as amended by Certificate of Incorporation on Change of Name dated March 30, 2004 and Certificate of Deposit of Memorandum of Increase of Capital dated April 21, 2004 (See Exhibit 3.1) |
4.3 | Bye-laws of the Registrant (See Exhibit 3.2) |
4.4 | Indenture, dated as of May 1, 2004, among the Company, Assured Guaranty U.S. Holdings Inc. and The Bank of New York, as trustee (Incorporated by reference to Exhibit 4.1 to Form 10-Q for the quarter ended March 31, 2004) |
4.5 | Indenture, dated as of December 1, 2006, entered into among Assured Guaranty Ltd., Assured Guaranty U.S. Holdings Inc. and The Bank of New York, as trustee (Incorporated by reference to Exhibit 4.1 to Form 8-K filed on December 20, 2006) |
4.6 | First Supplemental Subordinated Indenture, dated as of December 20, 2006, entered into among Assured Guaranty Ltd., Assured Guaranty U.S. Holdings Inc. and The Bank of New York, as trustee (Incorporated by reference to Exhibit 4.2 to Form 8-K filed on December 20, 2006) |
4.7 | Replacement Capital Covenant, dated as of December 20, 2006, between Assured Guaranty U.S. Holdings Inc. and Assured Guaranty Ltd., in favor of and for the benefit of each Covered Debtholder (as defined therein) (Incorporated by reference to Exhibit 4.1 to Form 8-K filed on December 20, 2006) |
4.8 | Amended and Restated Trust Indenture dated as of February 24, 1999 between Financial Security Assurance Holdings Ltd. and the Senior Debt Trustee (Incorporated by reference to Exhibit 4.1 to Financial Security Assurance Holdings Ltd.'s Registration Statement to Form S-3 (#333-74165)) |
273
Exhibit Number | Description of Document |
4.9 | Form of Assured Guaranty Municipal Holdings Inc., formerly known as Financial Security Assurance Holdings Ltd. 67/8% Quarterly Interest Bond Securities due 2101 (Incorporated by reference to Exhibit 4.1 to Form 10-Q for the quarter ended March 31, 2010) |
4.10 | Form of Assured Guaranty Municipal Holdings Inc., formerly known as Financial Security Assurance Holdings Ltd. 6.25% Notes due November 1, 2102 (Incorporated by reference to Exhibit 4.2 to Form 10-Q for the quarter ended March 31, 2010) |
4.11 | Form of Assured Guaranty Municipal Holdings Inc., formerly known as Financial Security Assurance Holdings Ltd. 5.60% Notes due July 15, 2103 (Incorporated by reference to Exhibit 4.3 to Form 10-Q for the quarter ended March 31, 2010) |
4.12 | Supplemental indenture, dated as of August 26, 2009, between Assured Guaranty Ltd., Financial Security Assurance Holdings Ltd. and U.S. Bank National Association, as trustee (Incorporated by reference to Exhibit 99.1 to Form 8-K filed on September 1, 2009) |
4.13 | Indenture, dated as of November 22, 2006, between Financial Security Assurance Holdings Ltd. and The Bank of New York, as Trustee (Incorporated by reference to Exhibit 4.1 to Financial Security Assurance Holdings Ltd.'s Form 8-K filed on November 28, 2006) |
4.14 | Form of Financial Security Assurance Holdings Ltd. Junior Subordinated Debenture, Series 2006-1 (Incorporated by reference to Exhibit 10.3 to Financial Security Assurance Holdings Ltd.'s Form 8-K filed on November 25, 2002) |
4.15 | Supplemental indenture, dated as of August 26, 2009, between Assured Guaranty Ltd., Financial Security Assurance Holdings Ltd. and The Bank of New York Mellon, as trustee (Incorporated by reference to Exhibit 99.2 to Form 8-K filed on September 1, 2009) |
4.16 | First Supplemental Indenture, to be dated as of June 24, 2009, between Assured Guaranty US Holdings Inc., Assured Guaranty Ltd. and The Bank of New York Mellon, as trustee (including the form of 8.50% Senior Note due 2014 of Assured Guaranty US Holdings Inc.) (Incorporated by reference to Exhibit 4.1 to Form 8-K filed on June 23, 2009) |
4.17 | Officers’ Certificate, dated June 20, 2014, related to 5.000% Senior Notes due 2024, containing form of 5.000% Senior Notes due 2024 as Exhibit A thereto (Incorporated by reference to Exhibit 4.1 to Form 8-K filed on June 20, 2014) |
10.1 | Guaranty by Assured Guaranty Re Ltd. in favor of Assured Guaranty Re Overseas Ltd., amended and restated as of May 1, 2014 (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended June 30, 2014) |
10.2 | Put Agreement between Assured Guaranty Corp. and Woodbourne Capital Trust [I][II][III][IV] (Incorporated by reference to Exhibit 10.6 to Form 10-Q for the quarter ended March 31, 2005) |
10.3 | Custodial Trust Expense Reimbursement Agreement (Incorporated by reference to Exhibit 10.7 to Form 10-Q for the quarter ended March 31, 2005) |
10.4 | Assured Guaranty Corp. Articles Supplementary Classifying and Designating Series of Preferred Stock as Series A Perpetual Preferred Stock, Series B Perpetual Preferred Stock, Series C Perpetual Preferred Stock, Series D Perpetual Preferred Stock (Incorporated by reference to Exhibit 10.8 to Form 10-Q for the quarter ended March 31, 2005) |
10.5 | Purchase Agreement among Dexia Holdings Inc., Dexia Credit Local S.A. and the Company dated as of November 14, 2008 (Incorporated by reference to Exhibit 99.1 to Form 8-K filed on November 17, 2008) |
10.6 | Amended and Restated Revolving Credit Agreement dated as of June 30, 2009 among FSA Asset Management LLC, Dexia Crédit Local S.A. and Dexia Bank Belgium S.A. (Incorporated by reference to Exhibit 10.1 to Form 8-K filed on July 8, 2009) |
10.7 | First Amendment to Amended and Restated Revolving Credit Agreement dated as of September 20, 2010 among FSA Asset Management LLC, Dexia Crédit Local S.A. and Dexia Bank Belgium S.A. (Incorporated by reference to Exhibit 10.11 to Form 10-K for the year ended December 31, 2013) |
10.8 | Second Amendment to Amended and Restated Revolving Credit Agreement dated as of May 16, 2012 among FSA Asset Management LLC, Dexia Crédit Local S.A. and Dexia Bank Belgium S.A. (Incorporated by reference to Exhibit 10.12 to Form 10-K for the year ended December 31, 2013) |
10.9 | Assignment Pursuant to the Amended and Restated Revolving Credit Agreement, as amended, dated as of December 12, 2013 between Belfius Bank SA/NV and Dexia Crédit Local S.A. (Incorporated by reference to Exhibit 10.13 to Form 10-K for the year ended December 31, 2013) |
10.10 | Master Repurchase Agreement (September 1996 Version) dated as of June 30, 2009 between Dexia Crédit Local S.A. and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.2.1 to Form 8-K filed on July 8, 2009) |
274
Exhibit Number | Description of Document |
10.11 | Annex I-Committed Term Repurchase Agreement Annex dated as of June 30, 2009 between Dexia Crédit Local S.A. and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.2.2 to Form 8-K filed on July 8, 2009) |
10.12 | ISDA Master Agreement (Multicurrency-Cross Border) dated as of June 30, 2009 among Dexia SA, Dexia Crédit Local S.A. and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.3.1 to Form 8-K filed on July 8, 2009) |
10.13 | Schedule to the 1992 Master Agreement, Guaranteed Put Contract, dated as of June 30, 2009 among Dexia Crédit Local S.A., Dexia SA and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.3.2 to Form 8-K filed on July 8, 2009) |
10.14 | Put Option Confirmation, Guaranteed Put Contract, dated June 30, 2009 to FSA Asset Management LLC from Dexia SA and Dexia Crédit Local S.A. (Incorporated by reference to Exhibit 10.3.3 to Form 8-K filed on July 8, 2009) |
10.15 | ISDA Credit Support Annex (New York Law) to the Schedule to the ISDA Master Agreement, Guaranteed Put Contract, dated as of June 30, 2009 between Dexia Crédit Local S.A. and Dexia SA and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.3.4 to Form 8-K filed on July 8, 2009) |
10.16 | ISDA Master Agreement (Multicurrency-Cross Border) dated as of June 30, 2009 among Dexia SA, Dexia Crédit Local S.A. and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.4.1 to Form 8-K filed on July 8, 2009) |
10.17 | Schedule to the 1992 Master Agreement, Non-Guaranteed Put Contract, dated as of June 30, 2009 among Dexia Crédit Local S.A., Dexia SA and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.4.2 to Form 8-K filed on July 8, 2009) |
10.18 | Put Option Confirmation, Non-Guaranteed Put Contract, dated June 30, 2009 to FSA Asset Management LLC from Dexia SA and Dexia Crédit Local S.A. (Incorporated by reference to Exhibit 10.4.3 to Form 8-K filed on July 8, 2009) |
10.19 | ISDA Credit Support Annex (New York Law) to the Schedule to the ISDA Master Agreement, Non-Guaranteed Put Contract, dated as of June 30, 2009 between Dexia Crédit Local S.A. and Dexia SA and FSA Asset Management LLC (Incorporated by reference to Exhibit 10.4.4 to Form 8-K filed on July 8, 2009) |
10.20 | First Demand Guarantee Relating to the “Financial Products” Portfolio of FSA Asset Management LLC issued by the Belgian State and the French State and executed as of June 30, 2009 (Incorporated by reference to Exhibit 10.5 to Form 8-K filed on July 8, 2009) |
10.21 | Guaranty, dated as of June 30, 2009, made jointly and severally by Dexia SA and Dexia Crédit Local S.A., in favor of Financial Security Assurance Inc. (Incorporated by reference to Exhibit 10.6 to Form 8-K filed on July 8, 2009) |
10.22 | Indemnification Agreement (GIC Business) dated as of June 30, 2009 by and among Financial Security Assurance Inc., Dexia Crédit Local S.A. and Dexia SA (Incorporated by reference to Exhibit 10.7 to Form 8-K filed on July 8, 2009) |
10.23 | Pledge and Administration Agreement, dated as of June 30, 2009, among Dexia SA, Dexia Crédit Local S.A., Dexia Bank Belgium SA, Dexia FP Holdings Inc., Financial Security Assurance Inc., FSA Asset Management LLC, FSA Portfolio Asset Limited, FSA Capital Markets Services LLC, FSA Capital Markets Services (Caymans) Ltd., FSA Capital Management Services LLC and The Bank of New York Mellon Trust Company, National Association (Incorporated by reference to Exhibit 10.8 to Form 8-K filed on July 8, 2009) |
10.24 | Separation Agreement, dated as of July 1, 2009, among Dexia Crédit Local S.A., Financial Security Assurance Inc., Financial Security Assurance International, Ltd., FSA Global Funding Limited and Premier International Funding Co. (Incorporated by reference to Exhibit 10.9 to Form 8-K filed on July 8, 2009) |
10.25 | Funding Guaranty, dated as of July 1, 2009, made by Dexia Crédit Local S.A. in favor of Financial Security Assurance Inc. and Financial Security Assurance International, Ltd. (Incorporated by reference to Exhibit 10.10 to Form 8-K filed on July 8, 2009) |
10.26 | Reimbursement Guaranty, dated as of July 1, 2009, made by Dexia Crédit Local S.A. in favor of Financial Security Assurance Inc. and Financial Security Assurance International, Ltd. (Incorporated by reference to Exhibit 10.11 to Form 8-K filed on July 8, 2009) |
10.27 | Amended and Restated Strip Coverage Liquidity and Security Agreement, dated as of July 1, 2009, between Assured Guaranty Municipal Corp. and Dexia Crédit Local S.A. (Incorporated by reference to Exhibit 10.31 to Form 10-K for the year ended December 31, 2013) |
275
Exhibit Number | Description of Document |
10.28 | First Amendment to Amended and Restated Strip Coverage Liquidity and Security Agreement, dated as of June 30, 2014, between Assured Guaranty Municipal Corp. and Dexia Crédit Local S.A. (Incorporated by reference to Exhibit 10.6 to Form 10-Q for the quarter ended June 30, 2014) |
10.29 | Indemnification Agreement (FSA Global Business), dated as of July 1, 2009, by and between Financial Security Assurance Inc., Assured Guaranty Ltd. and Dexia Crédit Local S.A. (Incorporated by reference to Exhibit 10.13 to Form 8-K filed on July 8, 2009) |
10.30 | Pledge and Administration Annex Amendment Agreement dated as of July 1, 2009 among Dexia SA, Dexia Crédit Local S.A., Dexia Bank Belgium SA, Dexia FP Holdings Inc., Financial Security Assurance Inc., FSA Asset Management LLC, FSA Portfolio Asset Limited, FSA Capital Markets Services LLC, FSA Capital Markets Services (Caymans) Ltd., FSA Capital Management Services LLC and The Bank of New York Mellon Trust Company, National Association (Incorporated by reference to Exhibit 10.14 to Form 8-K filed on July 8, 2009) |
10.31 | Put Confirmation Annex Amendment Agreement dated as of July 1, 2009 among Dexia SA and Dexia Crédit Local S.A. and FSA Asset Management LLC and Financial Security Assurance Inc. (Incorporated by reference to Exhibit 10.15 to Form 8-K filed on July 8, 2009) |
10.32 | Master Repurchase Agreement between FSA Capital Management Services LLC and FSA Capital Markets Services LLC (Incorporated by reference to Exhibit 10.20 to Form 10-Q for the quarter ended June 30, 2009) |
10.33 | Confirmation to Master Repurchase Agreement (Incorporated by reference to Exhibit 10.21 to Form 10-Q for the quarter ended June 30, 2009) |
10.34 | Master Repurchase Agreement Annex I (Incorporated by reference to Exhibit 10.22 to Form 10-Q for the quarter ended June 30, 2009) |
10.35 | Pledge and Intercreditor Agreement, among Dexia Crédit Local, Dexia Bank Belgium S.A., Financial Security Assurance Inc. and FSA Asset Management LLC, dated November 13, 2008 (Incorporated by reference to Exhibit 10.3 to Financial Security Assurance Holdings Ltd.'s Form 10-Q for the quarter ended September 30, 2008) |
10.36 | Amended and Restated Pledge and Intercreditor Agreement, dated as of February 20, 2009, between Dexia Crédit Local, Dexia Bank Belgium S.A., Financial Security Assurance Inc., FSA Asset Management LLC, FSA Capital Markets Services LLC and FSA Capital Management Services LLC (Incorporated by reference to Exhibit 10.19 to Financial Security Assurance Holdings Ltd.'s Form 10-K for the year ended December 31, 2008) |
10.37 | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust I (Incorporated by reference to Exhibit 99.5 to Financial Security Assurance Holdings Ltd.'s Form 10-Q for the quarter ended June 30, 2003) |
10.38 | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust II (Incorporated by reference to Exhibit 99.6 to Financial Security Assurance Holdings Ltd.'s Form 10-Q for the quarter ended June 30, 2003) |
10.39 | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust III (Incorporated by reference to Exhibit 99.7 to Financial Security Assurance Holdings Ltd.'s Form 10-Q for the quarter ended June 30, 2003) |
10.40 | Put Option Agreement, dated as of June 23, 2003 by and between FSA and Sutton Capital Trust IV (Incorporated by reference to Exhibit 99.8 to Financial Security Assurance Holdings Ltd.'s Form 10-Q for the quarter ended June 30, 2003) |
10.41 | Contribution Agreement, dated as of November 22, 2006, between Dexia S.A. and Financial Security Assurance Holdings Ltd. (Incorporated by reference to Exhibit 10.4 to Financial Security Assurance Holdings Ltd.'s Form 8-K filed on November 28, 2006) |
10.42 | Replacement Capital Covenant, dated as of November 22, 2006, by Financial Security Assurance Holdings Ltd. (Incorporated by reference to Exhibit 10.5 to Financial Security Assurance Holdings Ltd.'s Form 8-K filed on November 28, 2006) |
10.43 | Agreement and Amendment between Dexia Holdings Inc., Dexia Credit Local S.A. and the Company dated as of June 9, 2009 (Incorporated by reference to Exhibit 10.1 to Form 8-K filed on June 12, 2009) |
10.44 | Stock Purchase Agreement, dated as of December 22, 2014, between Assured Guaranty Corp. and Radian Guaranty Inc. |
10.45 | Summary of Annual Compensation* |
276
Exhibit Number | Description of Document |
10.46 | Director Compensation Summary (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended March 31, 2014)* |
10.47 | Assured Guaranty Ltd. 2004 Long-Term Incentive Plan, as amended and restated as of May 7, 2009 and as amended through the Third Amendment (Incorporated by reference to Exhibit 10.2 to Form 10-Q for the quarter ended March 31, 2014)* |
10.48 | Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan to be used with employment agreement (Incorporated by reference to Exhibit 10.34 to Form 10-K for the year ended December 31, 2005)* |
10.49 | Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.35 to Form 10-K for the year ended December 31, 2005)* |
10.50 | Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan to be used with employment agreement (Incorporated by reference to Exhibit 10.66 to Form 10-K for the year ended December 31, 2007)* |
10.51 | Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.67 to Form 10-K for the year ended December 31, 2007)* |
10.52 | Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan to be used with employment agreement (Incorporated by reference to Exhibit 10.71 to Form 10-K for the year ended December 31, 2008)* |
10.53 | Non-Qualified Stock Option Agreement for Outside Directors under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.19 to Form 10-Q for the quarter ended June 30, 2009)* |
10.54 | 2010 Form of Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan to be used with employment agreement (Incorporated by reference to Exhibit 10.3 to Form 10-Q for the quarter ended March 31, 2010)* |
10.55 | 2010 Form of Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan for use without employment agreement (Incorporated by reference to Exhibit 10.4 to Form 10-Q for the quarter ended March 31, 2010)* |
10.56 | 2012 Form of Executive Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.7 to Form 10-Q for the quarter ended March 31, 2012)* |
10.57 | 2013 Form of Executive Non-Qualified Stock Option Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended March 31, 2013)* |
10.58 | Restricted Stock Unit Agreement for Outside Directors under Assured Guaranty Ltd. 2004 Long Term Incentive Plan (Incorporated by reference to Exhibit 10.37 to Form 10-K for the year ended December 31, 2005)* |
10.59 | Restricted Stock Unit Agreement for Outside Directors under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended June 30, 2007)* |
10.60 | Restricted Stock Unit Agreement for Outside Directors under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended June 30, 2008)* |
10.61 | Form of amendment to Restricted Stock Unit Awards for Outside Directors (Incorporated by reference to Exhibit 10.3 to Form 10-Q for the quarter ended June 30, 2008)* |
10.62 | Restricted Stock Agreement for Outside Directors under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.2 to Form 10-Q for the quarter ended June 30, 2008)* |
10.63 | 2014 Restricted Stock Agreement for Outside Directors under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.5 to Form 10-Q for the quarter ended June 30, 2014)* |
10.64 | Form of Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan to be used with employment agreement (Incorporated by reference to Exhibit 10.6 to Form 10-Q for the quarter ended March 31, 2011)* |
10.65 | Form of Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan to be used without employment agreement (Incorporated by reference to Exhibit 10.7 to the Form 10-Q for the quarter ended March 31, 2011)* |
10.66 | 2012 Form of Executive Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.8 to Form 10-Q for the quarter ended March 31, 2012)* |
10.67 | 2013 Form of Executive Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.2 to Form 10-Q for the quarter ended March 31, 2013)* |
277
Exhibit Number | Description of Document |
10.68 | 2014 Form of Executive Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.2 to Form 10-Q for the quarter ended June 30, 2014)* |
10.69 | 2012 Form of Executive Performance-Based Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.9 to Form 10-Q for the quarter ended March 31, 2012)* |
10.70 | 2013 Form of Executive Performance-Based Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.3 to Form 10-Q for the quarter ended March 31, 2013)* |
10.71 | 2014 Form of Executive Performance-Based Restricted Stock Unit Agreement under Assured Guaranty Ltd. 2004 Long-Term Incentive Plan (Incorporated by reference to Exhibit 10.3 to Form 10-Q for the quarter ended June 30, 2014)* |
10.72 | First Amendment to the Restricted Stock Unit Agreement for Outside Directors (Incorporated by reference to Exhibit 10.106 to Form 10-K for the year ended December 31, 2012)* |
10.73 | Assured Guaranty Ltd. Employee Stock Purchase Plan, as amended through the second amendment (Incorporated by reference to Exhibit 10.5 to Form 10-Q for the quarter ended March 31, 2013)* |
10.74 | Assured Guaranty Ltd. Performance Retention Plan (As Amended and Restated as of February 14, 2008 for Awards Granted during 2007) (Incorporated by reference to Exhibit 10.50 to Form 10-K for the year ended December 31, 2007)* |
10.75 | Assured Guaranty Ltd. Performance Retention Plan (As Amended and Restated as of February 14, 2008) (Incorporated by reference to Exhibit 10.58 to Form 10-K for the year ended December 31, 2007)* |
10.76 | Terms of Performance Retention Award, Four Year Installment Vesting Granted on February 9, 2011 for participants subject to $1 million limit (Incorporated by reference to Exhibit 10.5 to Form 10-Q for the quarter ended March 31, 2011)* |
10.77 | Terms of Performance Retention Award Four Year Installment Vesting Granted on February 9, 2012 for participants Subject to $1 million Limit (Incorporated by reference to Exhibit 10.10 to Form 10-Q for the quarter ended March 31, 2012)* |
10.78 | Terms of Performance Retention Award Four Year Installment Vesting Granted on February 7, 2013 for Participants Subject to $1 million Limit (Incorporated by reference to Exhibit 10.4 to Form 10-Q for the quarter ended March 31, 2013)* |
10.79 | Terms of Performance Retention Award Four Year Installment Vesting Granted on February 5, 2014 for Participants Subject to $1 million Limit (Incorporated by reference to Exhibit 10.4 to Form 10-Q for the quarter ended June 30, 2014)* |
10.80 | Assured Guaranty Ltd. Executive Severance Plan (Incorporated by reference to Exhibit 10.5 to Form 10-Q for the quarter ended March 31, 2012)* |
10.81 | Form of Acknowledgement Letter for Participants in Assured Guaranty Ltd. Executive Severance Plan (Incorporated by reference to Exhibit 10.11 to Form 10-Q for the quarter ended March 31, 2012)* |
10.82 | Assured Guaranty Ltd. Perquisite Policy (Incorporated by reference to Exhibit 10.6 to Form 10-Q for the quarter ended March 31, 2012)* |
10.83 | Form of Indemnification Agreement between the Company and its executive officers and directors (Incorporated by reference to Exhibit 10.42 to Form 10-K for the year ended December 31, 2005)* |
10.84 | Assured Guaranty Ltd. Executive Officer Recoupment Policy (Incorporated by reference to Exhibit 10.69 to Form 10-K for the year ended December 31, 2008)* |
10.85 | Form of Acknowledgement of Assured Guaranty Ltd. Executive Officer Recoupment Policy (Incorporated by reference to Exhibit 10.70 to Form 10-K for the year ended December 31, 2008)* |
10.86 | Assured Guaranty Ltd. Supplemental Employee Retirement Plan, as amended and restated effective January 1, 2009 and as amended by the First, Second, Third, Fourth and Fifth Amendments (Incorporated by reference to Exhibit 10.1 to Form 10-Q for the quarter ended September 30, 2012)* |
10.87 | Assured Guaranty Corp. Supplemental Executive Retirement Plan as amended through the Third Amendment thereto (Incorporated by reference to Exhibit 4.5 to Form S-8 (#333-178625))* |
10.88 | Financial Security Assurance Holdings Ltd. 1989 Supplemental Executive Retirement Plan (amended and restated as of December 17, 2004) (Incorporated by reference to Exhibit 10.4 to Financial Security Assurance Holdings Ltd.'s Form 8-K filed on December 17, 2004)* |
278
Exhibit Number | Description of Document |
10.89 | Amendment to the Financial Security Assurance Holdings Ltd. 1989 Supplemental Employee Retirement Plan (Incorporated by reference to Exhibit 10.29 to Form 10-Q for the quarter ended June 30, 2009)* |
10.90 | Financial Security Assurance Holdings Ltd. 2004 Supplemental Executive Retirement Plan, as amended on February 14, 2008 (Incorporated by reference to Exhibit 10.3 to Financial Security Assurance Holdings Ltd.'s Form 8-K filed on February 15, 2008)* |
10.91 | Separation Agreement, dated February 4, 2015, between Robert B. Mills and the Registrant* |
12.1 | Computation of Ratio of Earnings to Fixed Charges |
21.1 | Subsidiaries of the Registrant |
23.1 | Accountants Consent |
31.1 | Certification of CEO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes‑Oxley Act of 2002 |
31.2 | Certification of CFO Pursuant to Exchange Act Rules 13A-14 and 15D-14, as Adopted Pursuant to Section 302 of the Sarbanes‑Oxley Act of 2002 |
32.1 | Certification of CEO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑ Oxley Act of 2002 |
32.2 | Certification of CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes‑ Oxley Act of 2002 |
101.1 | The following financial information from Registrant's Annual Report on Form 10-K for the year ended December 31, 2014 formatted in XBRL (eXtensible Business Reporting Language) interactive data files pursuant to Rule 405 of Regulation S-T: (i) Consolidated Balance Sheets at December 31, 2014 and 2013; (ii) Consolidated Statements of Operations for the years ended December 31, 2014, 2013 and 2012; (iii) Consolidated Statements of Comprehensive Income for the years ended December 31, 2014, 2013 and 2012; (iv) Consolidated Statements of Shareholders' Equity for the years ended December 31, 2014, 2013 and 2012; (v) Consolidated Statements of Cash Flows for the years ended December 31, 2014, 2013 and 2012; and (vi) Notes to Consolidated Financial Statements. |
* | Management contract or compensatory plan |
279
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Assured Guaranty Ltd. | ||
By: | /s/ Dominic J. Frederico Name: Dominic J. Frederico Title: President and Chief Executive Officer | |
Date: February 26, 2015
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
Name | Position | Date | ||||||||||||
/s/ Robin Monro‑Davies Robin Monro‑Davies | Chairman of the Board; Director | February 26, 2015 | ||||||||||||
/s/ Dominic J. Frederico Dominic J. Frederico | President and Chief Executive Officer; Director | February 26, 2015 | ||||||||||||
/s/ Robert A. Bailenson Robert A. Bailenson | Chief Financial Officer (Principal Financial and Accounting Officer and Duly Authorized Officer) | February 26, 2015 | ||||||||||||
/s/ Francisco L. Borges Francisco L. Borges | Director | February 26, 2015 | ||||||||||||
/s/ G. Lawrence Buhl G. Lawrence Buhl | Director | February 26, 2015 | ||||||||||||
/s/ Stephen A. Cozen Stephen A. Cozen | Director | February 26, 2015 | ||||||||||||
/s/ Bonnie L. Howard Bonnie L. Howard | Director | February 26, 2015 | ||||||||||||
/s/ Patrick W. Kenny Patrick W. Kenny | Director | February 26, 2015 | ||||||||||||
/s/ Simon W. Leathes Simon W. Leathes | Director | February 26, 2015 | ||||||||||||
/s/ Michael T. O'Kane Michael T. O'Kane | Director | February 26, 2015 | ||||||||||||
/s/ Yukiko Omura Yukiko Omura | Director | February 26, 2015 | ||||||||||||
280