FINANCIAL SECURITY ASSURANCE HOLDINGS LTD
Business       3     Item   1A.       Risk   Factors       39
Unresolved Staff Comments.       42
Properties       42     Item   3.       Legal   Proceedings       42
Submission of Matters to a Vote of Security Holders       42     PART II
Market for Registrant’s Common Equity, Related   Stockholder Matters and Issuer Purchases of Equity Securities       43
As of and for the Year Ended December 31,                 2005       2004       2003       2002       2001                 (in millions)         SUMMARY OF OPERATIONS(a)                                                 Gross premiums   written       $   833.8       $   832.0       $   895.8       $   803.7       $   485.6         Net premiums   written       577.7       587.8       614.3       532.7       319.6         Net premiums   earned       404.1       395.0       356.4       314.9       231.0         Net investment   income       200.8       172.1       154.0       139.1       128.9         Net income       326.1       378.6       298.1       197.0       205.7         BALANCE SHEET DATA(a)                                                 Investment   portfolio(b)       18,621.1       13,836.8       9,493.2       5,037.4       3,214.1         Total assets(b)       22,001.6       17,081.0       12,407.6       7,045.8       4,309.9         Deferred premium   revenue       2,375.1       2,095.4       1,845.0       1,448.2       1,095.0         Losses and loss   adjustment expense       205.7       179.9       233.4       223.6       114.4         Notes payable       430.0       430.0       430.0       430.0       330.0         GIC and VIE   debt(b)       14,947.1       10,444.1       6,639.4       2,409.9       601.8         Common   shareholders’ equity       2,822.9       2,611.3       2,219.2       1,919.4       1,633.8         ADDITIONAL DATA                                                 Qualified   statutory capital(c)       2,417.5       2,280.9       2,104.3       1,876.1       1,593.6         Total claims-paying   resources(d)       5,675.8       5,230.6       4,657.7       3,819.1       3,217.3         Net par   outstanding       337,483.0       317,742.6       289,200.2       263,010.5       217,110.8         Net insurance in   force (principal + interest)       480,184.5       444,511.5       403,019.4       364,908.5       300,637.1         Total dividends       71.1       22.9       —       11.7       31.1                             (a)           Prepared in accordance with accounting principles generally accepted in the United States of America. (b)          VIE balances are included beginning July 1, 2003 due to the adoption of Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.” (c)           Amounts are statutory data for FSA and therefore differ from comparable GAAP amounts. (d)          Total claims-paying resources refers to a term used by Moody’s to evaluate adequacy of claims-paying resources and credit ratings. Moody’s uses its judgment in making adjustments to some of the measures. The Company provides the adjusted balances. This term represents the sum of statutory capital, statutory unearned premium reserve, present value of future net installment premiums, statutory loss reserve, credit available under standby line of credit facility and money market committed preferred trust securities. 44    Item 7.   Management’s Discussion and Analysis of Financial Condition and Results of Operations. Overview Management’s principal business objective is to grow the intrinsic value of the Company over the long term. To this end, it seeks to accumulate an insured portfolio of conservatively underwritten municipal and asset-backed obligations and attractively priced guaranteed investment contracts (“GICs”), in order to produce a reliable, predictable earnings stream. Strategically, the Company seeks to maintain balanced capabilities across domestic and international municipal and asset-backed markets in order to allow the flexibility to pursue the most attractive opportunities available at any point in the business cycle. References to the “Company” are to Financial Security Assurance Holdings Ltd. together with its subsidiaries. To reflect accurately how management evaluates the Company’s operations and progress toward long-term goals, this discussion employs both measures promulgated in accordance with accounting principles generally accepted in the United States of America (GAAP measures) and measures not so promulgated (non-GAAP measures). Although the measures identified as non-GAAP in this discussion should not be considered substitutes for GAAP measures, management considers them key performance indicators and employs them in determining compensation. Non-GAAP measures therefore provide investors with important information about the way management analyzes its business and rewards performance. Comparing 2005 GAAP results with those of 2004, the Company’s total revenues decreased 14.5% to $981.2 million, and net income decreased 13.9% to $326.1 million. Gross premiums written increased 0.2% to $833.8 million. Shareholders’ equity increased 8.1% to $2.8 billion. Results of Operations Premiums Net Earned and Written Premiums             Year Ended December 31,                 2005       2004       2003                 (in millions)         Premiums written, net of reinsurance       $   577.7       $   587.8       $   614.3         Premiums earned, net of reinsurance       404.1       395.0       356.4         Net premiums   earned excluding refundings and prepayments       349.8       350.6       324.9                        Net premiums earned increased 2.3% in 2005 and 10.8% in 2004. Excluding the effects of refundings and prepayments, net premiums earned decreased 0.2% in 2005 and increased 7.9% in 2004. Refundings and prepayments result from interest-rate movements and other factors outside the Company’s control, and no assurance can be given that refundings and prepayments will continue at the recent level. The recent slower growth rate in earned premiums is a function of the relatively higher contribution from U.S. municipal originations, which generally have longer maturities and therefore  slower earnings, and a decline in asset-backed earned premiums. New Business Production For each accounting period, the Company estimates the present value of originations (“PV originations”). This non-GAAP measure consists of the total present value of premiums originated (“PV  45    premiums originated”) by Financial Security Assurance Inc. and its subsidiaries (“FSA”) and the present value of net interest margin (“PV NIM”) originated by the Company’s financial products (“FP”) business (the “FP Segment”). The Company generated PV originations of $1,014.0 million in 2005, $927.2 million in 2004 and $894.6 million in 2003. Management believes that by disclosing the components of PV originations in addition to premiums written, the Company provides investors with a more comprehensive description of its new business activity in a given period. Present Value of Premiums Originated The GAAP measure “gross premiums written” captures premiums collected in a given period, whether collected for business originated in the period, or in installments for business originated in prior periods. It is not a precise measure of current-period originations because a significant portion of the Company’s premiums are collected in installments. Therefore, to measure current-period premium production, management calculates the gross present value of premium installments originated in the accounting period and combines it with premiums received upfront in the accounting period, which produces the non-GAAP measure PV premiums originated. The Company’s insurance policies and insured credit derivative contracts are generally non-cancelable and remain outstanding for years from date of inception, in some cases 30 years or longer. Accordingly, current-period premium production, as distinct from earned premium, represents premiums to be earned in the future. Viewed at a policy level, installment premiums are generally calculated as a fixed premium rate multiplied by the insured debt outstanding as of dates established by the terms of the policy. Because the actual installment premiums received could vary from the amount estimated at the time of origination based on variances in the actual outstanding debt balances as of the pre-established dates, the realization of PV premiums originated could be greater or less than the amount reported. Installment premiums are not recorded in the financial statements until due, which is a function of the terms of each insurance policy. Future installment premiums are not captured in premiums earned or premiums written, the most comparable GAAP measures. Management therefore uses PV premiums originated to evaluate current business production. PV premiums originated reflects estimated future installment premiums discounted to their present value, as well as upfront premiums, but only for business originated during the period. To calculate PV premiums originated, management discounts an estimate of all future installment premium receipts. The Company calculates the discount rate for PV premiums originated as the average pre-tax yield on its insurance investment portfolio for the previous three years. This rate serves as a proxy for the return that could be achieved if the premiums had been received upfront. The estimated installment premium receipts are determined based on each installment policy’s projected par balances outstanding multiplied by its premium rate. The Company’s Transaction Oversight Groups estimate the relevant schedule of future par balances outstanding for each insurance policy with installment premiums. At the time of origination, projected debt schedules are generally based on good faith estimates developed and used by the parties negotiating the transaction. Year-to-year comparisons of PV premiums originated are affected by the application of a different discount rate each year. The discount rate employed by the Company for this purpose was 5.30% for 2005 originations, 5.62% for 2004 originations and 5.91% for 2003 originations. Management intends to revise the discount rate in future years according to the same methodology, in order to reflect specific return results realized by the Company. 46     Reconciliation of Gross Premiums Written to Non-GAAP PV Premiums Originated             Year Ended December 31,                 2005       2004       2003                 (in millions)         Gross premiums written       $   833.8       $   832.0       $   895.8         Gross installment premiums received       (348.6   )   (332.4   )   (345.2   )     Gross upfront premiums originated       485.2       499.6       550.6         PV estimated installment premiums originated       436.2       353.9       299.9         PV premiums   originated       $   921.4       $   853.5       $   850.5           Financial Guaranty Insurance Originations Unless otherwise noted, percentage changes in this discussion and analysis compare the period named with the comparable period of the prior year. The tables below show the PV premiums originated and gross par amount insured by FSA in its three major business sectors for transactions closed in the period. U.S. Municipal New Originations             Year Ended December 31,                 2005       2004       2003         Gross par insured   (in billions)       $   64.8       $   49.0       $   54.9         Gross PV premiums   originated (in millions)       484.5       433.5       483.1                        Driven by steady new-money issuance and high levels of refundings, the U.S. municipal new-issue market reached approximately $408.4 billion in 2005, on a sale-date basis, a 13.4% increase from $360.1 billion in 2004 and a 6.4% increase from the record level of $383.7 billion in 2003. Insurance penetration was approximately 56%, compared with 54% in 2004 and 50% in 2003. In all three years, low interest rates, strong demand for refundings and continuing needs for infrastructure investment drove high levels of municipal borrowing. Of the insured par amount of municipal bonds sold each year, FSA guaranteed approximately 26% in 2005, 24% in 2004 and 27% in 2003. Including both primary and secondary U.S. municipal obligations with closing dates in 2005, FSA’s U.S. municipal par originated increased 32.3%, and the related PV premiums originated increased 11.8%. In 2005, the mix of business shifted toward a greater volume of general obligations, including school bonds, and other tax-backed transactions that tend to have lower absolute premiums than revenue bonds because of their lower risk. In 2004, FSA’s U.S. municipal par originated declined 10.7%, and the related PV premiums originated declined 10.3%. FSA increased its PV premiums originated in the health care revenue and general obligation sectors during 2004, but those increases were offset by declines in the non-general obligation tax-supported sector and various revenue-backed sectors. 47    U.S. Asset-Backed New Originations             Year Ended December 31,                 2005       2004       2003         Gross par insured (in   billions)       $   24.5       $   48.6       $   15.6         Gross PV premiums   originated (in millions)       195.4       234.2       177.6                        The Company’s U.S. asset-backed gross par insured decreased 49.7% in 2005 and rose 211% in 2004. The Company’s associated PV premiums originated decreased 16.6% in 2005 and rose 31.9% in 2004. In 2005, PV premiums originated declined less than par originated due to a shift toward longer duration transactions in the mix of business. Declines in PV premiums from high-premium net interest margin mortgage-backed transactions, which are generally designed to securitize excess cash flow generated by an issuer’s residential mortgage loan securitizations, and other residential mortgage transactions represented most of the decrease in PV premiums originated. Consumer finance and CDO PV premiums originated increased. In 2004, PV premiums originated did not grow as much as par insured because most of the growth in par volume came from pooled corporate and residential mortgage transactions of Triple-A underlying credit quality. Such high-quality transactions tend to have relatively low premium rates but tend to achieve good returns on equity. International New Originations             Year Ended December 31,                 2005       2004       2003         Gross par insured   (in billions)       $   14.1       $   10.2       $   10.3         Gross PV premiums   originated (in millions)       241.5       185.8       189.8                        Full-year international par insured for 2005 increased 37.9% and international PV premium originations increased 30.0%. In 2005, public infrastructure provided the greatest share of PV premiums, as tight spreads constrained the international asset-backed business. Full-year international par insured for 2004 approximated that of the prior year, and international PV premium originations decreased 2.1%. PV premiums for international originations are translated into U.S. dollars using month-end currency exchange rates. Actual premiums received could differ from this amount due to exchange-rate fluctuations. Financial Products Originations The FP Segment, in which the Company conducts business through affiliates (the “GIC Affiliates”), produces net interest margin (“FP NIM”) rather than insurance premiums. Like installment premiums, the PV NIM originated is expected to be earned and collected in future periods. GICs are issued at or converted into LIBOR-based floating-rate obligations, with proceeds invested in or converted into LIBOR-based floating-rate investments intended to result in profits from a higher investment rate than borrowing rate. The difference between the current-year investment revenue and borrowing cost is the FP NIM. The non-GAAP measure PV NIM represents the difference between the present value of estimated interest to be received on the investments and the present value of estimated interest to be paid on liabilities issued in the form of GICs, net of the expected results of derivatives used to hedge interest-rate risk. The Company’s future positive interest-rate spread can be reasonably estimated and generally relates to contracts or security instruments that extend for multiple years. Net interest income and net interest expense are reflected in the statements of operations and comprehensive income but are limited to current-year earnings. As GIC contracts extend beyond the current period, management considers the non-GAAP measure PV NIM to be a useful indicator of future  48    FP NIM to be earned and includes it in the non-GAAP measure adjusted book value (“ABV”) as an element of intrinsic value that is not found in GAAP book value. The majority of municipal GICs issued by the GIC Affiliates relate to debt service reserve funds and construction funds in support of municipal bond transactions. These funds may be drawn unexpectedly, with the result that the actual timing and amount of repayments may differ from the original estimates, which in turn would affect the realization of the estimate of PV NIM originated in a given accounting period. PV outstanding is the sum of cumulative years’ reported PV premiums originated and PV NIM originated, less what has been earned or adjusted due to changes in estimates as described above. Installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable by the Company and represent a claim to future cash flows. Therefore, management includes these amounts in its estimate of ABV. Financial Products PV NIM Originated             Year Ended December 31,                 2005       2004       2003                 (in millions)         Gross present   value of future net interest margin originated       $   92.6       $   73.7       $   44.1                        PV NIM originated increased 25.6% in 2005 as the book of business increased. Throughout 2005, the Company generally took a cautious approach to asset acquisitions because of the narrow spread environment, although it did find some long-dated purchasing opportunities. The growth in the book of business is largely a function of increased GIC issuance activity in both municipal and structured GICs. In 2004, PV NIM originated increased 67.1%. Operating Earnings and Adjusted Book Value In addition to evaluating the Company’s GAAP financial information, management evaluates the Company’s business under certain non-GAAP performance measures that management refers to as operating earnings and ABV. Management uses these two metrics to measure the Company’s performance and to calculate long-term incentive compensation and the annual bonus pool. Management refers to this information in its presentations with rating agencies and the Board of Directors. While these metrics are not substitutes for reported results under GAAP, management regards operating earnings and ABV as meaningful indicators of operational performance that supplement the information available from GAAP measures. While GAAP provides a uniform comprehensive basis of accounting, management believes that operating earnings are an important additional measure for providing a more complete understanding of the Company’s results of operations. The Company defines operating earnings as net income before the effects of fair-value adjustments for two items: 1.                Interest-rate derivatives that are intended to hedge fixed-rate assets and liabilities but do not meet the criteria for hedge accounting treatment under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) (“economic interest-rate hedges”); and 2.                FSA-insured credit default swaps (“CDS”) that have investment-grade underlying credit quality and that must be marked to fair value under SFAS 133. Periodic unrealized gains and losses related to economic interest-rate hedges arise in both the financial guaranty and financial products business segments, caused primarily by the one-sided mark-to- 49    market derivative valuations prescribed by SFAS 133 for derivatives that do not qualify for “hedge-accounting treatment” under GAAP. Under the Company’s definition of operating earnings, the economic effect of these hedges is recognized, which, for interest rate swaps, generally results in any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life. Futures contracts used to hedge interest-rate risk include both the embedded current net interest paid or received, as well as the value of the future net interest cash flow. Therefore, to reflect the equivalent of any cash paid or received being recognized ratably as an expense or revenue over the hedged item’s life, the current interest accretion amount embedded in the mark-to-market value of open futures positions is added back to operating earnings. CDS contracts are generally non-cancelable prior to maturity, and the Company views insured CDS risks as comparable to other insured risks. In a typical CDS transaction, the Company, in exchange for an upfront or periodic premium, indemnifies the insured party for economic losses (in excess of some agreed-upon deductible) related to debt obligations of specified obligors, structured such that the risk insured is investment grade without the benefit of the credit protection provided by the Company. In the event a CDS were to migrate below investment grade, the fair-value impact would be fully reflected in operating earnings. Operating earnings are subject to certain general and specific limitations that investors should carefully consider. For example, as stated above, unlike financial accounting, there is no comprehensive, authoritative guidance for management reporting. The Company’s operating earnings are not defined terms within GAAP and may not be comparable to similarly titled measures reported by other companies. Unlike GAAP, the Company’s operating earnings presentation does not represent a comprehensive basis of accounting. Investors, therefore, should not compare the Company’s performance with that of other financial guaranty companies based upon operating earnings. Operating earnings results are only meant to supplement GAAP results by providing additional information regarding the operational and performance indicators that are most closely used by management, the Company’s Board of Directors and rating agencies to assess performance. Other limitations arise from the specific adjustments that management makes to GAAP results to derive operating earnings results. For example, in reversing the unrealized gains and losses that result from application of SFAS 133 to derivatives that do not qualify for hedge accounting, management focuses on the long-term economic effectiveness of those instruments relative to the underlying hedged item and isolates the effects of interest-rate volatility and changing credit spreads on the fair value of such instruments during the period. Under GAAP, the effects of these factors on the fair value of the derivative instruments (but not the underlying hedged item) tend to show more volatility in the short term. While the Company believes that its presentation presents the economic substance of its FP Segment and the business of FSA Global Funding Limited (“FSA Global”), a variable interest entity (“VIE”) whose results are consolidated with those of the Company, the presentation understates GAAP earnings volatility. Operating earnings also do not reflect earnings variability related to CDS fair-value adjustments. A significant percentage of the Company’s CDS exposures subject to fair-value adjustments are considered Triple-A or Super Triple-A (defined as credit quality based on loss protection greater than 1.3 times the Triple-A standard), and the Company does not intend to trade these highly rated, highly structured contracts. Accordingly, management believes it is probable that the financial impact of the fair-value adjustments for the insured CDS will sum to zero over the finite terms of the exposures, which are typically five to ten years at inception. For this reason, management believes that the market volatility of credit-spread pricing, the primary driver of the Company’s change in fair-value results, should not influence a measure of the Company’s operating performance and therefore excludes CDS fair-value adjustments from operating earnings. Operating earnings increased 3.1% in 2005 and 22.8% in 2004. 50    The following table reconciles net income to non-GAAP operating earnings for the years addressed: Reconciliation of Net Income to Non-GAAP Operating Earnings             Year Ended December 31,                 2005       2004       2003                 (in millions)         Net income       $   326.1       $   378.6       $   298.1         Less fair-value adjustments for economic   interest-rate hedges, net of taxes(1)       (15.0   )   17.1       9.3         Less fair-value adjustments for insured CDS,   net of taxes       7.2       37.7       23.4         Operating   earnings       $   333.9       $   323.8       $   265.4            (1)          See following table for a more detailed presentation of fair-value adjustments for economic interest-rate hedges. Fair-Value Adjustments for Economic Interest-Rate Hedges             Year Ended December 31,                 2005       2004       2003                 (in millions)         Fair-value adjustment for economic interest-rate   hedges—FP Segment        $   (24.7   )   $   (6.4   )   $   2.0         Fair-value adjustment for economic interest-rate   hedges—VIEs       5.7       112.9       42.5         VIE minority interest       (4.1   )   (80.2   )   (30.2   )     Tax effect       8.1       (9.2   )   (5.0   )     Total fair-value   adjustments for economic interest-rate hedges       $   (15.0   )   $   17.1       $   9.3           Adjusted Book Value To calculate ABV, the following adjustments, on an after-tax basis, are made to shareholders’ equity (GAAP “book value”): 1.                addition of unearned premium revenues, net of amounts ceded to reinsurers; 2.                addition of the present value of future installment premiums, net of amounts ceded to reinsurers; 3.                addition of the present value of future net interest margin; 4.                subtraction of the deferred costs of acquiring policies; 5.                elimination of the effect of fair-value adjustments for insured CDS; 6.                elimination of the fair-value adjustments for economic interest-rate hedges; and 7.                elimination of unrealized gains or losses on investments. Management considers ABV an operating measure of the Company’s intrinsic value. Book value reflects an estimate of loss for all insured risks made at the time of contract origination. ABV adds back certain GAAP liabilities and deducts certain GAAP assets (adjustments 1, 4, 5, 6 and 7 in the calculation above), and captures the estimated value of future contractual cash flows related to transactions in force as of the balance sheet date (adjustments 2 and 3 in the calculation above) because installment payment contracts, whether in the form of premiums or NIM, are generally non-cancelable and represent a claim to future cash flows. An investor attempting to evaluate the Company using GAAP measures alone would not have the benefit of this information. In addition, investors may consider the growth of ABV to be a performance measure indicating the degree to which management has succeeded in building a reliable  51    source of future earnings. Certain of the Company’s compensation formulas are based, in part, on the ABV growth rate. The limitations of the ABV metric are that it reflects the accelerated realization of certain assets and liabilities through equity and relies on an estimate of the amount and timing of the receipt of installment premiums and future net interest margin. Actual installment premium receipts could vary from the amount estimated due to differences between actual and estimated insured debt balances outstanding. Actual net interest margin results could vary from the amount estimated based on sales of investments prior to maturity and variances in the actual timing and amount of repayment associated with flexible-draw GICs that the Company issues. ABV excludes the fair-value adjustments of investment-grade insured CDS and the fair-value adjustments of derivatives that hedge interest-rate risk but do not qualify for hedge accounting under SFAS 133. Adjustments 1, 2 and 3 above represent the sum of cumulative years’ reported PV premiums originated and PV NIM originated, less what has been earned or adjusted due to changes in estimates as described above. Adjustments 1 and 2 in the calculation of ABV together represent unearned premiums that have been collected and the Company’s best estimate of the present value of its future premium revenues (comprising current- and prior-period originations that have not yet been earned). Debt schedules related to installment transactions change from time to time. Critical assumptions underlying adjustment 2 are discussed above under “New Business Production—Financial Guaranty Insurance Originations.” As discussed above under “New Business Production—Financial Products Originations,” the Company calculates PV NIM originated (adjustment 3) because net interest income and net interest expense reflected in the statements of operations and comprehensive income are limited to current-year earnings. The Company’s future positive interest-rate spread from outstanding GIC business can be estimated and generally relates to contracts or security instruments that extend for multiple years. Management therefore includes it in ABV as another element of intrinsic value not found in GAAP book value. Adjustment 4 reflects the realization in equity of deferred costs associated with the origination of premiums. Through adjustments 5 and 6, the effect of certain items that are excluded from operating earnings are also excluded from ABV. As explained in the preceding discussion of operating earnings, management expects the financial impact of the CDS fair-value adjustments, reflected in adjustment 5, to sum to zero over the finite terms of the related exposures. Derivatives reflected in adjustment 6 reduce, on an economic basis, the interest-rate risk of fixed-rate assets and liabilities held in the FP Segment and FSA Global portfolios, although they do not meet SFAS 133 hedge-accounting requirements. The Company uses such derivatives to hedge against interest-rate volatility, rather than to speculate on the direction of interest rates. The intent of management is to hold the derivatives to expected maturity along with the related hedged fixed-rate assets or liabilities. In addition, through adjustment 7, ABV excludes the effect of fair-value adjustments made to investments and reflected in other comprehensive income. As the objective is to optimize long-term stable earnings, management generally seeks to minimize turnover and therefore any unrealized investment gain or loss is subtracted from book value to exclude it from the ABV metric. In the event that an investment is liquidated prior to its maturity, any related gain or loss is reflected in both earnings and ABV without further adjustment. Shareholders’ equity was $2.8 billion and non-GAAP ABV was $3.9 billion at December 31, 2005. During 2005, ABV grew 14.0%. The following table reconciles book value to non-GAAP ABV for the years presented: 52    Reconciliation of Book Value to Non-GAAP Adjusted Book Value             As of December 31,                 2005       2004                 (in millions)         Shareholders’   equity (book value)       $   2,822.9       $   2,611.3         After-tax   adjustments:                         Plus net unearned premium revenues       981.4       868.6         Plus present value of net future installment   premiums and PV NIM       556.0       497.3         Less net deferred acquisition costs       217.8       200.3         Less fair-value adjustments for insured CDS       37.4       31.4         Less fair-value of economic interest-rate hedges       20.8       36.1         Less unrealized   gains on investments       156.2       199.8         Adjusted book   value       $   3,928.1       $   3,509.6           Net Investment Income and Realized Gains Net investment income increased 16.7% in 2005 and 11.7% in 2004, primarily due to higher invested balances arising from new business writings and dividend income from the Company’s equity investment in XL Financial Assurance Ltd (“XLFA”). Income from Investments             Year Ended December 31,                 2005       2004       2003                 (in millions)         Net investment   income       $   200.8       $   172.1       $   154.0         Net realized   gains (losses)       8.3       (0.5   )   5.1         Effective tax rate on   investment income excluding effects of realized gains and losses and variable   interest entities       13.3   %   9.2   %   9.2   %                    Realized gains and losses are generally a by-product of the normal investment management process and may vary substantially from period to period. 53    Losses and Loss Adjustment Expenses The provision for losses and loss adjustment expenses was $25.4 million in 2005, $20.6 million in 2004 and  $34.5 million in 2003. Activity in the liability for losses and loss adjustment expenses, which consists of case and non-specific reserves, is summarized as follows:             Case Reserve Activity for the   Year Ended December 31,                 2005       2004       2003                 (in millions)         Gross balance at   January 1       $   80.6       $   121.9       $   134.0         Less reinsurance recoverable       35.4       59.2       76.0         Net balance at   January 1       45.2       62.7       58.0         Transfer from non-specific   reserve       10.3       30.7       12.7         Restructured transactions       —       (13.9   )   (2.2   )     Paid (net of   recoveries) related to:                                 Current year       —       —       —         Prior year       (2.0   )   (34.3   )   (5.8   )     Total paid       (2.0   )   (34.3   )   (5.8   )     Net balance at   December 31       53.5       45.2       62.7         Plus reinsurance recoverable       36.3       35.4       59.2         Gross balance at   December 31       $   89.8       $   80.6       $   121.9                       Non-Specific Reserve   Activity for the   Year Ended December 31,                 2005       2004       2003                 (in millions)         Balance at   January 1       $   99.3       $   111.5       $   89.7         Provision for   losses                                 Current year       20.4       20.4       22.4         Prior year       5.0       0.2       12.1         Transfers to case   reserves       (10.3   )   (30.7   )   (12.7   )     Restructured transactions       1.5       (2.1   )   —         Balance at   December 31       115.9       99.3       111.5         Total case and non-specific   reserves       $   205.7       $   179.9       $   233.4           The gross and net par amounts outstanding on transactions with case reserves were $612.7 million and $519.5 million, respectively, at December 31, 2005. Net case reserves consisted primarily of seven CDO transactions and one municipal transaction, which collectively accounted for approximately 94% of the total net case reserve. The remaining 11 exposures were in various sectors. 54     Case and non-specific reserves for losses and loss adjustment expenses are discounted when established using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established. During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on the reserve for in-force business. Case reserves increased $8.3 million, primarily due to deterioration of specific CDO risks. See Note 16 to the Consolidated Financial Statements in Item 8. During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior-year reserves and $3.2 million related to reassumptions of previously ceded business, partially offset by reserve releases, which were primarily related to favorable experience in the CDO portfolio. The non-specific reserve decreased $12.2 million in 2004, primarily due to transfers from the non-specific reserve to case reserves of $30.7 million, partially offset by loss expense of $20.6 million. Case reserves decreased $17.5 million due to a large, voluntarily accelerated transaction that had a $34.3 million payment and to reclassifications of $13.9 million from reserves to asset valuation accounts for refinanced transactions, partially offset by transfers from the non-specific reserve of $30.7 million. See Note 22 to the Consolidated Financial Statements in Item 8. Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s revised estimate of loss, actual loss experience, its mix of business and economic conditions. The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves:             As of December 31,                 2005       2004         Case reserve   discount rate       3.13%–5.90   %   3.13%–5.90   %     Non-specific   reserve discount rate       1.20%–7.95   %   1.20%–7.95   %     Current experience   factor       1.8       2.0           The primary estimates affecting the statistical calculation are probability of default and severity of loss given default. The Company applies its experience factor to the statistical calculation to reflect actual loss experience in terms of both frequency and severity. Historically, defaults on guaranteed obligations have been infrequent, but the size of resulting claims have varied widely due to both the differing sizes of the obligations guaranteed and the significant variability of the severity experienced. Severity represents the magnitude of loss, which is calculated as claims paid minus total recoveries, expressed as a percentage of par guaranteed. Recoveries include salvage value of assets and amounts due from reinsurers. Actual claim frequency and severity experience may evolve over time, affected by many factors, including changes in the insured portfolio’s distribution across sectors and underlying ratings, as well as changes in the economy and the political environment. The Company’s loss reserving methodology is designed to reflect these factors. Changes in the sectors and underlying credit quality of the transactions are captured in the formula directly, while changes in the economy and political environment are captured in the experience factor. Given the broad diversification of FSA’s insured portfolio, management believes that a significant shift in overall portfolio quality is unlikely to occur except in a catastrophic economic environment. It is therefore necessary to look at particular sectors when examining the sensitivity of the insured portfolio to changes in underlying loss assumptions. Management believes that different analyses are required for the two broad sectors of the insured portfolio, asset-backed obligations and municipal credits. Asset-backed obligations insured by FSA are secured by pools of assets. While the assets in a given transaction are generally of one type (such as automobile loans, residential mortgage loans, etc.), they are  55    diversified within that asset type. Due to characteristically low default frequency, losses on insured asset-backed transactions have been manageable, in management’s view, despite variability. Management believes severity is not the primary determinant of possible loss in a portfolio of insured asset-backed obligations. Since introducing a non-specific reserve in 1993, actual aggregate losses have been reasonably consistent with management’s expectation in the majority of asset-backed categories, including insured obligations collateralized by automobile loan or residential mortgage debt of non-prime borrowers. The one exception involved senior bonds issued in 1998 and 1999 in connection with structured CDOs. In such a structure, the bonds insured by FSA are in second-loss positions, meaning that there are uninsured, subordinate bondholders or equity investors who must lose all of their investment outstanding at the time of default or earlier trigger event before the FSA-insured bonds become subject to loss. These transactions were structured to FSA’s requirement that the first-loss position provide FSA an investment-grade level of protection. The underlying assets supporting the insured obligations were pools of corporate bonds individually rated below investment grade. In this structure, multiple credits must fail before claims are triggered. In 2002, credit quality deteriorated across a broad spectrum of the corporate market, which led to projected claims on these transactions and charges to FSA’s statements of operations and comprehensive income, as well as an increase in the Company’s loss experience rate. Yet, even under this unprecedented stress scenario, the severity of the largest single loss was relatively modest. Accordingly, management considers default frequency the relevant factor driving adverse loss experience in the asset-backed sector and believes that a reasonably possible adverse change in default frequencies would not result in a material adverse adjustment to the non-specific loss reserve. Current asset-backed case reserves could vary from the current estimate of loss. In particular, the deterministic model used to determine case reserves for CDO transactions utilizes average cumulative default rates produced by a Monte Carlo simulation and applies those defaults to a cash flow model. While CDO exposures are affected by multiple variables, including default rates, collateral recovery rates, changes in interest rate movements and the prepayment speeds of the collateral, management believes default frequency is the key determinant of loss. Holding all other variables constant and assuming only that the CDO’s underlying corporate debt instruments were to default at a higher rate than the Monte Carlo average default rate, actual losses would exceed the current estimate. Applying a higher frequency of default, observed at the 90% confidence level, would result in additional present-value loss of $15 million. Management believes that a material adverse change to the loss estimate in its municipal risk sectors, excluding the health care category, would not occur under any reasonably possible scenario. While the Company has not experienced a loss in the health care sector, the potential severity of health care losses is comparatively high. Hospital facilities are single-purpose assets and a failing health care issuer is likely to be liquidated or acquired. If there is collateral associated with a health care credit, it is generally in the form of a hospital facility, the value of which is primarily driven by the community’s need for that facility. The more hospitals competing in a community, the more fragile the value of the hospital collateral is likely to be in a stress scenario. FSA addresses the severity risk in this sector through internal policies that limit exposure to any single credit. In a Standard & Poor’s Ratings Services (“S&P”) scenario analysis, S&P assumed 75% loss severity for health care credits, which means that a loss would equal 75% of par insured. If losses of this severity occurred in the lowest rated hospital exposure in FSA’s insured portfolio, the loss would be as much as $35.5 million on a pre-tax basis, net of reinsurance. A material adverse change from management’s current estimate of loss for municipal transactions with case reserves is considered unlikely because the only such case reserve is set near the full policy amount. FSA management believes that the liability it carries for losses and loss expenses is adequate to cover the net cost of claims. However, the loss liability is based on assumptions regarding the insured portfolio’s  56    probability of default and its severity of loss and there can be no assurance that the liability for losses will not exceed such estimates. The sensitivities described above are hypothetical and should be used with caution. The effect of variation in a particular assumption is calculated without changing any other assumption; in reality, changes in one factor may result in, or be accompanied by, changes in another, which might magnify or counteract the sensitivities. The Company is aware that there are differences regarding the method of measurement of the non-specific reserve among participants in the financial guaranty industry. Other financial guarantors may not establish a non-specific reserve in the manner described above, may call their non-specific reserve by a different name, such as, but not limited to “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time. Management and the industry expect accounting literature specific to the financial guaranty industry to evolve; however, management cannot predict or estimate the scope of the guidance or potential impact on the Company’s financial statements at this time. See Note 2 to the Consolidated Financial Statements in Item 8. At December 31, 2005, the reinsurance recoverable on unpaid losses from reinsurers and ceded par outstanding, by S&P rating levels, were as follows:     Reinsurer’s S&P Rating               Reinsurance   Recoverable       Ceded Par   Outstanding                 (in millions)         AAA           $   1.2           $   21,394.8         AA           34.8           85,941.9         A            0.3           13,270.8         Total           $   36.3           $   120,607.5           Impact of Hurricanes The Company evaluated its insured portfolio to assess the potential impact of Hurricanes Katrina, Rita and Wilma, which occurred in 2005. The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. Together, the non-specific reserve and case reserves represent the Company’s estimate of total loss liability. The Company believes that its total loss liability is adequate given the current information. Generally, when an insured credit deteriorates to a point where unreimbursed claims are expected, a case reserve is established. As of March 24, 2006, FSA had not received notice of payment default on any exposures related to Hurricanes Katrina, Rita or Wilma. To date, based on the Company’s review of its exposure, 11 credits, with aggregate net par exposure of $215.8 million, have the most significant risk of loss. FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. In the case of perpetual obligations, FSA may experience claims, but if the population returns in adequate numbers, reimbursement is likely. Eight of the 11 obligations with significant risk of loss are perpetual. The Company monitors its exposure to Hurricanes Katrina and Rita in Louisiana and Mississippi and has determined that no case reserve is required. Of the 11 credits with significant risk of loss, the Company has identified two high-priority risks. These risks are perpetual obligations, on which the Company may have to pay claims of up to $44.0 million in a worst-case scenario. However, in these two cases the Company expects that, so long as the population returns in adequate numbers, it would suffer only the lost interest income on any claims paid until the issuer repaid the Company at some point in the future. 57    In order for a community in Louisiana to restructure and potentially reduce its indebtedness, the Bond Commission, which is headed by the State Treasurer, must authorize such action. The State Treasurer has publicly represented that the Bond Commission will not permit any Louisiana municipality to declare bankruptcy. Municipalities in Mississippi are not authorized to file for bankruptcy and therefore have no mechanism under law to adjust their payment obligations. Unlike the corporate market, the municipal market has no private or equity source of capital and therefore lacks any means of starting fresh with a clean slate, with debts and liabilities rejected or adjusted in bankruptcy. To file for bankruptcy, or to leave rated indebtedness unpaid in a bankruptcy proceeding, would serve to tarnish the issuer and the region and effectively deny the subject municipality and similar issuers of debt within the state access to capital. Historically, rather than bankruptcy and adjustment of debt, financially distressed municipalities have been subjected to supervision and control by state-created authorities that act both as issuers of debt, secured by a discrete, newly identified revenue stream, and as fiscal monitors. Both the federal government and the executive and legislative branches of the affected states have considered or are expected to consider proposals or legislation to assist the municipalities and facilitate recovery. An example of such an enactment at the federal level is the Community Disaster Loan Act of 2005, under which the federal government has begun to make loans to affected municipalities. In addition, FSA’s asset-backed transactions, which are generally backed by pools of geographically diverse assets, show no unusual concentrations in the affected areas. The loss estimation process involves the exercise of considerable judgment and therefore FSA’s ultimate hurricane-related losses may be materially different from the current estimate and may affect future operating results. Other Operating Expenses Other operating expenses decreased 5.5% in 2005 compared with an increase of 6.5% in 2004. Excluding compensation expenses related to the Company’s deferred compensation and supplemental executive retirement plans, other operating expenses were $91.4 million in 2005, $80.8 million in 2004 and $65.6 million in 2003. The increases in 2005 and 2004 relate primarily to increased personnel costs and increases in premises and equipment expense as a result of the move to the Company’s new headquarters. The Company purchases assets selected by participants in the deferred compensation and supplemental executive retirement plans to economically defease the Company’s liability under these plans. Deferred compensation and supplemental executive retirement plan expenses are recorded in other operating expenses and the related income on the assets is recorded in other income. Such expenses and income therefore have no effect on net income. Financial Products Net Interest Margin FP operating NIM, a non-GAAP measure, is defined as the FP Segment net interest margin excluding fair-value adjustments for economic interest-rate hedges. Management uses FP operating NIM as a key performance measure of the Company’s financial products business. FP operating NIM was $40.5 million in 2005, $23.5 million in 2004 and $8.9 million in 2003. The increases in FP operating NIM were related primarily to the increase in the book of GIC business since the FP Segment commenced operations at the end of 2001. Prior-year balances have been reclassified to conform to the current-year presentation. NIM shown in accordance with classifications required under GAAP on the consolidated statements of operations and comprehensive income (“Total NIM”) is calculated as net interest income from financial products and VIEs, plus financial products net realized gains (losses), less net interest expense from financial products and VIEs. Total NIM was negative $11.2 million for 2005, negative $70.7 million for 2004 and negative $37.1 million for 2003, and primarily represents fixed-rate liabilities (which are swapped to a floating-rate obligation) funding floating-rate assets. The differences between Total NIM and FP  58    operating NIM relate primarily to the presentation of periodic interest income and expense on derivatives, intersegment transactions and VIE NIM, as discussed further below. The table below reconciles Total NIM with FP operating NIM. Reconciliation of Total NIM to Non-GAAP FP Operating NIM             Year Ended December 31,                 2005       2004       2003                 (in millions)         Total NIM       $   (11.2   )   $   (70.7   )   $   (37.1   )     Realized net interest   income from hedges of fixed-rate assets and liabilities included in net   realized and unrealized gains (losses) on derivative instruments       27.6       75.6       25.2         Intersegment income   related to refinanced transactions       28.2       24.8       24.1         VIE NIM(1)       (4.1   )   (4.8   )   (3.3   )     Intercompany adjustments       —       (1.4   )   —         FP operating NIM       $   40.5       $   23.5       $     8.9            (1)          VIE NIM represents the impact of consolidation of the VIEs on the Total NIM. Realized interest income and expense associated with economic interest rate hedges is an element of derivative gains and losses added back to calculate FP operating NIM. Derivatives that qualify for hedge accounting are classified in the consolidated statements of operations and comprehensive income with the underlying item being hedged. Gains and losses on derivatives that do not qualify for hedge accounting are shown under the caption net realized and unrealized gains (losses) on derivative instruments. Unrealized derivative gains and losses are excluded from FP operating NIM. Intersegment income relates primarily to intercompany notes held in the FP bond portfolio. In connection with the Company’s refinancing transactions, FSA obtains funds from the FP operations to fund claim payments, as discussed further in Note 22 to the Consolidated Financial Statements in Item 8, creating an interest-bearing intercompany note. This intercompany note is included in the assets of the FP Segment, with the related net interest income added to FP operating NIM, but is eliminated from the consolidated Total NIM. VIE NIM and FP NIM are combined on the consolidated statements of operations and comprehensive income. VIE NIM pertains to the net interest margin derived from transactions executed by FSA Global, Canadian Global Funding Corporation (“Canadian Global”) and Premier International Funding Co. (“Premier”). As the VIE NIM is considered part of the financial guaranty segment and not the FP Segment, this NIM component is subtracted to calculate FP NIM. See Note 25 to the Consolidated Financial Statements in Item 8. Net Realized and Unrealized Gains (Losses) on Derivative Instruments The components of net realized and unrealized gains (losses) on derivative instruments are shown in the table below:             Year Ended December 31,                 2005       2004       2003                 (in millions)         FP and VIE interest-rate derivatives       $   8.6       $   181.1       $   69.4         FP and VIE foreign currency derivatives       (189.8   )   91.3       118.3         Net CDS mark to fair value       11.1       56.4       34.8         Other       (2.4   )   0.5       4.9         Net realized and   unrealized derivative gains (losses)       $   (172.5   )   $   329.3       $   227.4           59    Credit Default Swaps FSA’s business includes insurance of CDS referencing diversified pools of obligations. The net par outstanding was $66.6 billion relating to these transactions at December 31, 2005 and $66.0 billion at December 31, 2004. Many of these transactions require periodic accounting adjustments to reflect an estimate of fair value (or the replacement cost of the Company’s financial guaranty contract) under SFAS 133. These transactions have generally been underwritten with Triple-A or higher levels of credit protection provided by significant deductibles that must be exhausted prior to claims under FSA’s guaranty. Adjustments required by SFAS 133 resulted in pre-tax income of $11.1 million for 2005, $56.4 million for 2004 and $34.8 million for 2003. The benefits during 2005, 2004 and 2003 resulted primarily from tightening credit spreads in the CDS market. None of these adjustments indicate any material improvement or deterioration in the underlying credit quality of FSA’s insured CDS portfolio. The gain or loss created by estimated fair-value adjustments will rise or fall each quarter based on estimated market pricing of highly rated swap guarantees and is not expected to be an indication of potential claims under FSA’s guaranty. Fair value is defined as the price at which an asset or a liability could be bought or sold in a current transaction between willing parties. The fair value is determined based on quoted market prices, if available. If quoted market prices are not available, as is the case primarily with CDS on pools of assets, then the determination of fair value is based on internally developed estimates. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and FSA’s ability to obtain reinsurance for its insured obligations. Due to changes in these factors, the gain or loss from derivative instruments may vary substantially from period to period. Absent any claims under FSA’s guaranty, any “losses” recorded in marking a guaranty to fair value will be reversed by an equivalent “gain” at or prior to the expiration of the guaranty, and any “gain” recorded will be reversed by an equal “loss” over the remaining life of the transaction. The average remaining life of these contracts is 3.2 years. The inception-to-date pre-tax gain on the CDS portfolio was $57.7 million at December 31, 2005 and $46.6 million at December 31, 2004. Given the very high credit quality of FSA’s insured CDS portfolio and the Company’s intent to hold to maturity, management believes that “losses” or “gains” attributable to marking these exposures to fair value do not reflect on the profitability of the Company in a meaningful way. FP and VIE Derivatives The Company utilizes interest-rate derivatives to hedge against fluctuations in interest rates and foreign currency derivatives to hedge against fluctuations in exchange rates. All gains and losses from changes in the fair-value of derivatives that do not qualify for hedge accounting under SFAS 133 are recognized immediately in the consolidated statements of operations and comprehensive income under the caption net unrealized and realized gains (losses) on derivatives. Hedge accounting is applied to derivatives designated as hedging instruments in a fair-value hedge, provided certain criteria are met. Income from Assets Acquired in Refinancing Transactions Income from assets acquired in refinancing transactions, excluding realized gains or losses, was $35.2 million in 2005, $31.6 million in 2004 and $25.3 million in 2003. The 2004 increase was due to refinancings of several insured transactions whereby the Company accelerated claim payments on transactions that had experienced events of default and acquired the obligations or underlying collateral in order to mitigate future claims. The increase in 2005 reflects the impact of a full year of income from transactions that were refinanced at various times during 2004. Equity in Earnings of Unconsolidated Affiliates Total equity in earnings of unconsolidated affiliates was a pre-tax gain of $1.2 million in 2005, a pre-tax loss of $3.3 million in 2004 and pre-tax income of $5.5 million in 2003. 60    As of December 31, 2004, the Company owned 34.1% of the SPS Holding Corp. (“SPS”), formerly Fairbanks Capital Holding Corp., and the Company’s interest in SPS had a book value of $49.6 million. As of December 31, 2003, the Company’s interest in SPS had a book value of $46.4 million, of which $7.6 million represented goodwill. In the third quarter of 2004, the Company determined that its $7.6 million of goodwill associated with its investment in SPS was impaired as a result of challenges encountered by SPS in acquiring new business. The Company’s equity in earnings from SPS was a pre-tax gain of $1.2 million in 2005, a pre-tax loss of $7.1 million in 2004 and a pre-tax loss of $13.5 million in 2003. In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. Under the terms of the agreement, the Company will receive cash payments through the first quarter of 2008 from a residual interest in mortgage servicing assets. The Company recorded an asset of $12.6 million representing this contingent payment asset. The Company and other prior shareholders indemnified the buyer for certain liabilities relating to SPS’s operations, including litigation and regulatory actions. The maximum indemnification obligation for SPS’s operations will not exceed approximately $34.0 million. The Company’s portion of this obligation is 37.4% or $12.7 million. As of December 31, 2005, the Company recorded a $5.1 million liability related to this indemnification representing the expected liability. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed and whether the assets are impaired. FSA’s 13% investment in preferred shares of XLFA, a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, the Company carries this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged a pre-tax amount of $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million. For the first three quarters of 2004 and all prior years, equity in earnings of unconsolidated affiliates included the results of XLFA. In accordance with EITF 02-14, “Whether an Investor Should Apply the Equity Method of Accounting for Investments Other Than Common Stock,” the Company no longer accounts for its investment in XLFA under the equity method of accounting. Effective October 1, 2004, the Company’s  investment in XLFA has been included in equity securities as an available-for-sale security. The fair value of the investment at December 31, 2005 and 2004 was $54.3 million. In March 2006, the XLFA Board of Directors approved a by-law amendment changing the coupon on XLFA’s preferred shares from the participating dividend described above to an 8.25% per annum fixed dividend effective January 1, 2006. Such by-law amendment remains subject to XLFA shareholder approval. Pending such approval, a dividend will be declared at this new rate on XLFA’s preferred shares for the first quarter of 2006. Variable Interest Entities Asset-backed and, to a lesser extent, municipal transactions insured by FSA may employ VIEs for a variety of purposes. A typical asset-backed transaction, for example, employs a VIE as the purchaser of the  61    securitized assets and as the issuer of the insured obligations. FSA’s participation is typically requested by the sponsor of the VIE or the underwriter, either via a bid process or on a sole-source basis. VIEs are typically owned by transaction sponsors or charitable trusts, although FSA may have an ownership interest in some cases. FSA maintains certain contractual rights and exercises varying degrees of influence over VIE issuers of FSA-insured obligations. FSA also bears some of the “risks and rewards” associated with the performance of VIEs’ assets. Specifically, as issuer of the financial guaranty insurance policy insuring a given VIE’s obligations, FSA bears the risk of asset performance (typically, but not always, after a significant depletion of overcollateralization, excess spread, a deductible or other credit protection). FSA’s underwriting policy is to insure only obligations that are otherwise investment grade. In addition, the VIE typically pays a periodic premium to FSA in consideration of the issuance by FSA of its insurance policy, with the VIE’s assets typically serving as the source of such premium, thereby providing some of the “rewards” of the VIE’s assets to FSA. VIEs are also employed by FSA in connection with “repackaging” of outstanding securities into new securities insured by FSA and with refinancing underperforming, non-investment-grade transactions insured by FSA. The degree of influence exercised by FSA over these VIEs varies from transaction to transaction, as does the degree to which “risks and rewards” associated with asset performance are assumed by FSA. While all transactions insured by FSA are included in the Company’s outstanding exposure, and losses under these obligations are reflected in the Notes to Consolidated Financial Statements, the assets and liabilities of these VIEs, except for refinanced transactions discussed below and in Note 22 to the Consolidated Financial Statements in Item 8, have not been consolidated with those of the Company for financial reporting purposes because the Company is not the primary beneficiary. In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”). FIN 46 addresses consolidation of VIEs that have one or both of the following characteristics: (a) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (b) the equity investors lack the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46R”). FIN 46R replaced FIN 46 and is effective for public companies for periods after December 15, 2003. The Company consolidates FSA Global, Canadian Global and Premier. The Company’s adoption of FIN 46 on July 1, 2003 resulted in a $1.9 billion aggregate increase in total assets and total liabilities. The differences upon consolidation were reflected as a cumulative effect of a change in accounting principle. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax in 2003. During the third quarter of 2004, the majority of the assets of Canadian Global were liquidated and its liabilities satisfied. There was no income statement effect from consolidating FSA Global and Premier. FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Affiliates. In each such case, the Company’s GIC liability and GIC asset are eliminated in consolidation. At December 31, 2005, $1,142.1 million was eliminated as a result of such consolidation. 62     The Company’s management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. All intercompany insured amounts between FSA and FSA Global or Canadian Global are excluded from the Notes to the Consolidated Financial Statements. In addition, the Company refinances certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated. See Note 22 to the Consolidated Financial Statements in Item 8. Taxes The Company’s effective tax rates were 27.3% in 2005, 19.0% in 2004 and 22.2% in 2003. The 2005 rate differs from the statutory rate of 35%, primarily due to tax-exempt interest income, minority interest, the Company’s reorganization of Financial Security Assurance International Ltd. (“FSA International”) and its intention to repatriate FSA International’s future earnings. In 2004 and 2003, the rates differed from the statutory rate of 35% primarily due to tax-exempt interest, income from FSA International, and minority interest, with the White Mountains indemnity payment (see below) and the expected repatriation of earnings of FSA International in 2005 also having an effect. The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provides guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005. In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%) applicable to certain earnings and profits of offshore subsidiaries repatriated during the current tax year and invested in the United States pursuant to a qualifying reinvestment plan in accordance with the Act. In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore, with the effect that 2005 and future income from FSA International have become subject to an increased effective U.S. tax rate. The impact on earnings reflects (1) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax and (2) $14.2 million related to 2005 earnings. Following a change in SPS’s investors in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when calculating the tax on its equity earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. Accordingly, for 2004 and 2003, equity in earnings from SPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, the Company, due to the pending sale of its investment in SPS, eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to reserve for additional taxes of approximately $1.6 million. In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated  63    for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2005. Critical Accounting Policies The Company’s critical accounting policies and estimates are described in Note 2 to the Consolidated Financial Statements in Item 8. Note 2 to the Consolidated Financial Statements includes a discussion of the financial guaranty accounting project that the FASB staff has undertaken to provide accounting guidance to the financial guaranty industry. Like other financial guarantors, the Company has received comments from the staff of the Securities and Exchange Commission (“SEC”) regarding its accounting for fixed income investments that are insured by FSA (“FSA-Insured Investments”). The Company cannot predict how the SEC staff will resolve this issue or the resulting effect on the Company’s consolidated financial statements. See “Item 1. Business—Investments Insured by the Company.” Liquidity and Capital Resources Liquidity The Company’s consolidated invested assets at December 31, 2005, net of unsettled security transactions, were $17,372.2 million, compared with the December 31, 2004 balance of $12,227.2 million. These balances include the change in the market value of the Company’s various portfolios, which had an unrealized gain position of $236.2 million at December 31, 2005, compared with an unrealized gain position of $294.5 million at December 31, 2004. These balances exclude (1) the effect of any economic interest-rate derivatives’ hedging and (2) assets in the VIE bond portfolio and assets acquired under refinancing transactions that the Company’s management believes are beyond the reach of the Company and its creditors. Included in these balances are short-term investments of $182.6 million at December 31, 2005 and $119.7 million at December 31, 2004. Cash and cash equivalents were $20.1 million at December 31, 2005 and $14.4 million at December 31, 2004. The Company includes variable-rate demand notes (“VRDN”) and auction-rate securities (“ARS”), which totalled $867.2 million at December 31, 2005 and $613.7 million at December 31, 2004, in its long-term bond portfolio. VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest-rate reset features and are traded in the marketplace through a bidding process. For management purposes, VRDN and ARS are managed as cash equivalents. Cash flow from operations was $653.0 million in 2005, $552.8 million in 2004 and $589.6 million in 2003. The increase in cash flow from operations in 2005 is attributable primarily to the increase in net interest received from the FP Segment due to the growth in book of business and premiums, partially offset by an increase in operating expenses and taxes paid. The increase in premium receipts was due primarily to increased refunding activity. The increase in taxes paid was due primarily to the repatriation of FSA International earnings. At December 31, 2005, Financial Security Assurance Holdings Ltd. (as a separate holding company, “FSA Holdings”) had cash and investments of $60.2 million available to fund the liquidity needs of its non-insurance operations. Because the majority of the Company’s operations are conducted through FSA, the long-term ability of the Company to service its debt will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA. 64    In its financial guaranty business, premiums and investment income are the Company’s primary sources of funds to pay its operating expenses, insured losses and taxes. In its FP Segment, the Company relies on net interest income to fund its net interest expense and operating expenses. Management believes that the Company’s operations provide sufficient liquidity to pay its obligations. If additional liquidity is needed or cash flow from operations significantly decreases, the Company can liquidate or utilize its investment portfolio as a source of funds in addition to its alternative liquidity arrangements, as discussed further below. The Company’s cash flows from operations are heavily dependent on market conditions, the competitive environment and the mix of business originated. In addition, payments made in settlement of the Company’s obligations in its insured portfolio may, and often do, vary significantly from year to year depending primarily on the frequency and severity of payment defaults and its decisions regarding whether to exercise its right to accelerate troubled insured transactions in order to mitigate future losses. In each of the three years reported, the Company has not drawn on any alternative sources of liquidity to meet its obligations, except that the Company has refinanced certain transactions using funds raised through its GIC Affiliates. The following is a summary of the Company’s contractual obligations at December 31, 2005: Contractual Obligations             Less than   1 Year       1–3 Years       3–5 Years       Greater than   5 years       Total                 (in millions)         Loss reserves(1)       $   (1.3   )       $   55.8               $   74.6               $   195.2           $   324.3         Long-term debt   obligations(2)       3,573.0           2,914.1               3,501.4               7,358.8           17,347.3         Operating lease   obligations       7.1           16.5               16.3               119.9           159.8         Total       $   3,578.8           $   2,986.4               $   3,592.3               $   7,673.9           $   17,831.4          (1)          Amounts represent the undiscounted estimated claim payments. (2)          Amounts include future implied interest accretion on zero-coupon obligations. At December 31, 2003, FSA Holdings held $152.9 million of surplus notes of FSA. During 2004, FSA repaid $44.0 million of those surplus notes. At December 31, 2005, FSA Holdings held $108.9 million of FSA surplus notes. Payments of principal or interest on such notes may be made only with the approval of the Superintendent of Insurance of the State of New York (the “New York Superintendent”). FSA Holdings employs surplus note purchases in lieu of capital contributions in order to allow it to withdraw funds from FSA through surplus note payments without reducing earned surplus, thereby preserving dividend capacity of FSA. FSA Holdings paid dividends of $71.1 million in 2005 and $22.9 million in 2004. It did not pay dividends in 2003. On July 31, 2003, FSA Holdings issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes. In September 2003, FSA Holdings called for redemption, on November 1, 2003, its 6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.95% Senior QUIDS. The unamortized debt issuance costs of $3.2 million for the 6.95% Senior QUIDS were charged to interest expense in 2003. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS. On November 26, 2002, FSA Holdings issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt.  65    FSA Holdings used a portion of the proceeds of this issuance to redeem in whole FSA Holdings’ $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097. Unamortized debt issuance costs of the retired debt of $4.1 million were charged to interest expense in 2002. On December 19, 2001, FSA Holdings issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt. FSA’s ability to pay dividends depends, among other things, upon FSA’s financial condition, results of operations, cash requirements and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York (the “New York Insurance Law”), FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the New York Superintendent or (b) adjusted net investment income during this period. Based on FSA’s statutory statements for 2004, and considering dividends that can be paid by its subsidiary, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2005 is approximately $153.8 million. FSA paid dividends of $87.0 million in 2005 and $30.0 million in 2004 and paid none in 2003. FSA International paid preferred dividends to XL Capital Ltd, its minority interest owner, of $6.9 million in 2005, $7.0 million in 2004 and $3.3 million in 2003. Additional Capital Resources FSA’s primary uses of funds are to pay operating expenses and to pay dividends to, or pay interest or principal on surplus notes held by, its parent. FSA’s funds are also required to satisfy claims under insurance policies in the event of default by an issuer of an insured obligation and the unavailability or exhaustion of other payment sources in the transaction, such as the cash flow or collateral underlying the obligations. FSA seeks to structure asset-backed transactions to address liquidity risks by matching insured payments with available cash flow or other payment sources. Insurance policies issued by FSA guaranteeing payments under bonds and other securities provide, in general, that payments of principal, interest and other amounts insured by FSA may not be accelerated by the holder of the obligation but are paid by FSA in accordance with the obligation’s original payment schedule or, at FSA’s option, on an accelerated basis. Insurance policies issued by FSA guaranteeing payments under CDS may provide for acceleration of amounts due upon the occurrence of certain credit events subject to single-risk limits specified in the New York insurance law. These policy provisions prohibiting or limiting acceleration of certain claims are mandatory under Article 69 of the New York Insurance Law and serve to reduce FSA’s liquidity requirements. Management believes that the Company’s expected operating liquidity needs, on both a short- and long-term basis, can be funded from its operating cash flow. In addition, the Company has a number of sources of liquidity available to pay claims on a short- and long-term basis: cash flow from premiums written, FSA’s investment portfolio and earnings thereon, reinsurance arrangements with third-party reinsurers, new borrowings through its GIC Affiliates, liquidity lines of credit with banks and capital market transactions. FSA has a credit arrangement aggregating $150.0 million, provided by commercial banks and intended for general application to transactions insured by FSA. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At  66    December 31, 2005, there were no borrowings under this arrangement, which expires on April 21, 2006, if not extended. FSA has a standby line of credit in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,220.0 million at December 31, 2005. The obligation to repay loans under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a ten-year term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. A ratings downgrade of FSA would result in an increase in the commitment fee. No amounts have been utilized under this commitment as of December 31, 2005. In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA 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 FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million for 2005 and $1.3 million for 2004 and was recorded as other operating expense in the Company’s Consolidated Financial Statements. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46 because it does not retain the majority of the residual benefits or expected losses. FSA-insured GICs subject the Company to risk associated with unexpected withdrawals of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn unexpectedly when construction of the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below Aa3 by Moody’s or AA- by S&P, unless the GIC provider posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below A3 by Moody’s or A- by S&P, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The Company manages this risk through the maintenance of liquid collateral and bank liquidity facilities. FSA Asset Management LLC (“FSAM”) has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 8, 2006, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this arrangement at December 31, 2005. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either S&P or Moody’s, and on neither S&P nor Moody’s having issued a rating to FSA below AA+ or Aa1, respectively. Capital Adequacy S&P, Moody’s and Fitch Ratings periodically assess the credits insured by FSA, and the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy the rating agencies’ capital adequacy criteria necessary to maintain FSA’s Triple-A ratings. Capital adequacy assessments by the rating agencies are generally based on FSA’s qualified statutory capital, which is the aggregate of  67    policyholders’ surplus and contingency reserves determined in accordance with statutory accounting principles. In the case of S&P, assessments of the credits insured by FSA are reflected in defined “capital charges,” which are reduced by reinsurance and collateral to the extent “credit” is allowed for such reinsurance and collateral. Credit provided for reinsurance under the S&P capital adequacy model is generally a function of the S&P rating of the reinsurer, as well as any collateral provided by the reinsurer. Capital charges on outstanding insured transactions and reinsurer ratings are subject to change by S&P at any time. In recent years, a number of Triple-A-rated reinsurers employed by FSA have been downgraded by S&P. Downgrade of these reinsurers by S&P to the Double-A category resulted in a decline in the credit allowed for reinsurance by S&P from 100% to 70% or 65% under present criteria. While a downgrade by S&P of all reinsurers to the Double-A category would not impair FSA’s Triple-A ratings, it would reduce the “margin of safety” by which FSA would survive a theoretical catastrophic depression modeled by S&P. A reduction by S&P in credit for reinsurance used by FSA would also be expected ultimately to reduce the Company’s return on equity to the extent that ceding commissions paid to FSA by such reinsurers were not increased to compensate for such reduction. FSA employs considerable reinsurance in its business to manage its single-risk exposures on insured credits. Any material increase in capital charges by S&P on FSA’s insured portfolio would likewise be expected to have an adverse effect on FSA’s margin of safety under the S&P capital adequacy model and, ultimately, the Company’s return on equity. The Company may seek to raise additional capital to replenish capital eliminated by any of the rating agencies and their assessment of FSA’s capital adequacy. Capital adequacy is one of the financial strength measures under Moody’s financial guarantor model. The model includes a penalty for risk concentration and recognizes a benefit for diversification. The published results reflect four metrics of financial strength relating to the insured portfolio’s credit quality, correlation risk, concentration of risk and capital adequacy. Moody’s assesses capital adequacy by comparing FSA’s claims-paying resources to a Moody’s-derived probability of potential credit losses. Moody’s loss distribution reflects FSA’s current distribution of risk by sector (municipal and asset-backed), the credit quality of insured exposures, correlations that exist between transactions, the credit quality of FSA’s reinsurers and the term to maturity of FSA’s insured portfolio. The published results compare levels of theoretical loss in the tail of this distribution to various measures of FSA’s claims-paying resources. Capital Expenditures The Company incurred approximately $27.9 million in capital expenditures, net of lease incentives, through 2005 for leasehold improvements, furniture and fixtures related to its new corporate headquarters. The Company has and expects to continue to fund these capital expenditures out of cash flows from operations. For additional information, see “Item 2. Properties.” Item 7A.                Quantitative and Qualitative Disclosures About Market Risk. Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments caused by interest rate, foreign exchange rate or equity price movements. The Company has exposure to market risk in (1)  the Investment Portfolio, (2) the FP Segment, which is driven by interest-rate spreads, and (3) its portfolio of insured CDS. Investment Portfolio Over 98% of the Company’s Investment Portfolio was invested in fixed-income securities at December 31, 2005. Changes in interest rates affect the value of the Company’s fixed-income portfolio. As interest rates rise, the fair value of fixed-income securities decreases. 68    Management’s primary objective in managing the Company’s Investment Portfolio is to generate an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity, subject to rating agency capital adequacy criteria that apply discount factors to investments based on their ratings. The Company bases its investment strategies on many factors, including the Company’s tax position, anticipated changes in interest rates, regulatory and rating agency criteria and other market factors. One internal investment manager and two external investment managers execute fixed-income investments on behalf of the Company. Management, with the approval of the Board of Directors, establishes guidelines for investment decisions. Sensitivity of the Company’s Investment Portfolio to interest-rate movements can be estimated by projecting a hypothetical increase in interest rates of 1.0%. Based on market values and interest rates at year-end 2005, this hypothetical increase in interest rates of 1.0% across the entire yield curve would result in an estimated after-tax decrease of $130.2 million in the fair value of the Company’s fixed-income portfolio, which would be recorded in other comprehensive income. Similarly, a hypothetical increase in interest rates of 1.0% would result in an estimated after-tax decrease of $11.3 million in the fair value of certain assets acquired under refinancing transactions, offset by an after-tax gain of $11.9 million on derivatives used to economically hedge the portfolio of assets acquired under refinancing transactions. The Company’s Investment Portfolio holdings are primarily U.S. dollar-denominated fixed-income securities, including municipal bonds, U.S. government and agency bonds and mortgage-backed, asset-backed, corporate and foreign securities. In calculating the sensitivity to interest rates for the taxable securities, U.S. Treasury rates are changed instantaneously by 1.0%. Tax-exempt securities are subjected to a change in the municipal Triple-A obligation curve that would be equivalent to a 1.0% taxable interest-rate change based on the average taxable/tax-exempt ratios for the prior 12 months. The simulation for tax-exempts calculates duration by taking into account the applicable call date if the bond is at a premium or the maturity date if the bond is at a discount. Financial Products and Variable Interest Entities FSAM manages the investments in the FP Investment Portfolio. The primary objectives in managing the FP Investment Portfolio are to generate a stable net interest margin, to maintain liquidity and to optimize risk-adjusted returns. The assets and liabilities in the FP Segment are hedged using interest-rate swaps or futures. A hypothetical increase in interest rates of 1% would result in an after-tax unrealized loss, which would be recorded in other comprehensive income, of $95.0 million to the asset portfolio, partially offset by a gain, which would be recorded in current income, of $80.3 million on derivatives used to economically hedge the asset portfolio. The same hypothetical increase in interest rates would result in a loss of $208.1 million on derivatives used to economically hedge the liability portfolio. This loss would be recorded in current income. The hypothetical increase in interest rates would result in a gain of $223.5 million in the liability portfolio. Changes in the fair value of the liability portfolio are not recorded in the financial statements. Since such asset and liability positions generally do not currently qualify for hedge accounting, a 1% increase in interest rates would result in lower reported net income of $127.8 million due to the net derivatives loss that would result from such an interest-rate decrease. Since the Company does not expect to trade these investments prior to maturity absent an unusually large demand for funds, it does not expect to recognize any material adverse impact to cash flows under the above scenario. The FP Investment Portfolio consists primarily of U.S. dollar-denominated asset-backed securities, U.S. agency and government securities and mortgage-backed securities. FSAM generally converts the interest rates of all fixed-rate assets and liabilities to floating rates using hedging instruments. As interest rates change, and assuming an economically effective fair-value hedging arrangement, the change in value of the fixed-income securities will be substantially offset by a similar but opposite change in value of the  69    related hedging instruments. To the extent the Company does not qualify for hedge accounting, such economic offsets cannot be presented in the financial statements, resulting in greater reported volatility arising from changes in interest rates. FSA-insured GICs subject the Company to risk associated with unexpected timing of withdrawal of principal allowed by the terms of the GICs. The majority of municipal GICs insured by FSA relate to debt service reserve funds and construction funds in support of municipal bond transactions. Debt service reserve fund GICs may be drawn unexpectedly when the underlying bond issuance suffers a debt service shortfall. Construction fund GICs may experience withdrawal deviation when the underlying municipal project does not proceed as expected. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below Aa3 by Moody’s or AA- by S&P unless the GIC provider posts collateral or otherwise enhances its credit. Most FSA-insured GICs further provide that in the event of an additional downgrade, generally below A- by S&P or A3 by Moody’s, GIC funds may be withdrawn irrespective of whether the GIC provider posts collateral or otherwise enhances its credit. FSAM also monitors the investments in the VIE Portfolio, which are generally held until maturity. The VIE fixed-rate portfolio is economically hedged against changes in interest rates largely through the use of interest-rate swap contracts, which convert fixed rates to floating rates. FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the notes (taking into account, in some cases, dedicated third-party liquidity). This matched funded structure is designed to minimize the market risks borne by FSA Global and FSA. FSA Global raises funds that are invested with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. FSA Global generally raises funds that are U.S. dollar-denominated or converted into U.S. dollars at LIBOR-based floating borrowing rates and invests them in FSA-insured obligations that: ·       are U.S. dollar denominated or converted into U.S. dollars at LIBOR-based floating rates, ·       mature prior to the maturity of the related FSA Global notes, and ·       pay a higher interest rate than the interest rate on the related FSA Global notes. The VIE fixed-rate investments and liabilities are economically hedged against changes in interest rates largely through the use of interest-rate swap contracts, which convert fixed rates to floating rates. A hypothetical increase in interest rates of 1% would result in an approximate after-tax loss of $24.8 million on the derivatives used to economically hedge the VIE asset and liability portfolios and would be recorded in current income. Credit Default Swaps Financial instruments that may be affected by changes in credit spreads include structured FSA-guaranteed CDS contracts. Such contracts are considered derivative instruments subject to fair-value accounting under SFAS 133. Because the Company generally provides credit protection under such contracts, widening credit spreads will have an adverse mark-to-fair-value effect on the Company’s consolidated statements of operations and comprehensive income while tightening credit spreads will have a positive effect. These contracts require the Company to make payments upon the occurrence of certain defined credit events relating to underlying obligations (generally fixed-income obligations), which may be individual obligations or a pool of obligations, subject to a deductible. These deductibles mitigate the risk of loss. If credit spreads of the underlying obligations change, the fair value of the related structured CDS changes. Changes in credit spreads are generally caused by changes in the market’s perception of the credit  70    quality of the underlying referenced obligations and by supply and demand factors that affect the level of credit spreads generally. The portfolio of CDS contracts consists primarily of synthetic structured credit derivatives guaranteed by the Company and is organized into various categories, which are defined by the underlying assets, credit rating, maturity dates and other terms. Changes in fair value of CDS contracts are generally due to changes in credit spreads. Because the portfolio of FSA-insured CDS is not traded, the Company has developed a series of asset credit-spread algorithms to estimate fair value. These algorithms derive fair value from several publicly available indices, depending on the types of assets referenced by the CDS. Management does not analyze the market sensitivity of its insured CDS portfolio for purposes other than to quantify the potential exposure to quarterly fair-value gain or loss. Management believes that each of the transactions for which it has provided CDS protection contains significant protections against loss and quarterly changes in credit spreads generally do not imply any fundamental change in future loss potential. Any quantitative fair-value risk information generated by the application of statistical techniques is limited by the methods, assumptions and parameters established in creating the model. The history of relevant asset credit-spread information is relatively short, and the insight gained by using such information to forecast potential future fair-value changes may therefore be limited. The effect of any change in credit spreads is recognized in current income. Generally, a sensitivity analysis is presented in terms of the effect of a predetermined basis-point change in pricing or credit spreads. However, due to the wide range of pricing of the CDS portfolio, management believes that this type of sensitivity analysis is not the most relevant measure. For example, a hypothetical one basis-point change in fair value would have a significantly greater impact on a CDS contract priced at five basis points than a CDS contract priced at 20 basis points. The Company has evaluated the sensitivity of the CDS contracts by calculating the effect of percentage changes in pricing. The following table summarizes the estimated after-tax effect of hypothetical changes in fair value of the Company’s portfolio of CDS contracts defined as derivatives. In accordance with SFAS 133, any changes in pricing would be recorded in the statements of operations. Hypothetical increase in CDS prices:             Estimated after-tax loss                 2005       2004                 (in millions)         +25%       $   56.4       $   41.9         +50%       112.7       84.4         +75%       169.1       126.9                     71
Management’s Discussion and Analysis of Financial   Condition and Results of Operations       45
Quantitative and Qualitative Disclosures About Market   Risk       68
Page     Report of Independent Registered Public Accounting   Firm       73     Consolidated   Balance Sheets as of December 31, 2005 and 2004       74     Consolidated   Statements of Operations and Comprehensive Income for the Years Ended             December 31,   2005, 2004 and 2003       75     Consolidated   Statements of Changes in Shareholders’ Equity for the Years Ended   December 31,             2005, 2004 and   2003       76     Consolidated Statements of Cash Flows for the Years   Ended December 31, 2005, 2004 and 2003       77     Notes to Consolidated Financial Statements       79     Schedule:             II Condensed   Financial Statements of Financial Security Assurance Holdings Ltd. as of             December 31,   2005 and 2004 and for the Years Ended December 31, 2005, 2004 and 2003       142       72     Report of Independent Registered Public Accounting Firm To Board of Directors and Shareholders of Financial Security Assurance Holdings Ltd.: In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the “Company”) at December 31, 2005 and December 31, 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 25 to the consolidated financial statements, in 2003 the Company changed its method of accounting for its interest in certain variable interest entities.    /s/ PricewaterhouseCoopers LLP             New York, New York             March 24, 2006              73     FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except share data)             As of December 31,                 2005       2004         ASSETS                         Bonds at fair value   (amortized cost of $4,219,344 and $3,863,909)       $   4,382,037       $   4,116,088         Equity securities at fair   value (cost of $54,370 and $54,300)       54,370       54,300         Short-term   investments       182,645       119,746         Variable interest   entities’ bonds at fair value (amortized cost of $1,155,832 and $1,342,489)       1,155,992       1,346,355         Variable interest   entities’ short-term investment portfolio       2,674       1,194         Financial products bond   portfolio at fair value (amortized cost of $11,754,330 and $7,882,739)       11,827,824       7,925,072         Financial products bond   portfolio pledged as collateral at fair value (amortized cost of $5,908)       —       5,913         Financial products short-term   investment portfolio       1,015,509       268,125         Total investment   portfolio       18,621,051       13,836,793         Assets acquired in refinancing transactions:                         Bonds at fair   value (amortized cost of $5,945 and $151,895)       9,145       157,036         Securitized loans       296,965       369,749         Other       161,763       222,423         Total assets   acquired in refinancing transactions       467,873       749,208         Total investments       19,088,924       14,586,001         Cash       20,117       14,353         Deferred acquisition   costs       335,129       308,015         Prepaid reinsurance   premiums       865,192       759,191         Investment in   unconsolidated affiliates       —       49,645         Reinsurance recoverable   on unpaid losses       36,339       35,419         Other assets       1,655,941       1,328,384         TOTAL ASSETS       $   22,001,642       $   17,081,008         LIABILITIES AND MINORITY INTEREST AND   SHAREHOLDERS’ EQUITY                         Deferred premium revenue       $   2,375,059       $   2,095,423         Losses and loss   adjustment expense       205,718       179,941         Guaranteed investment   contracts and variable interest entities’ debt       14,947,118       10,444,051         Deferred federal income   taxes       231,265       249,665         Notes payable       430,000       430,000         Minority interest       —       48,550         Minority interest in   variable interest entities       180,406       178,575         Accrued expenses and   other liabilities       809,174       843,525         TOTAL LIABILITIES   AND MINORITY INTEREST       $   19,178,740       14,469,730         COMMITMENTS AND CONTINGENCIES                         Common stock (200,000,000   shares authorized; 33,517,995 issued; par value of $.01 per share)       335       335         Additional paid-in   capital—common       905,190       905,080         Accumulated other   comprehensive income (net of deferred income taxes of $84,123 and $103,755)       156,229       199,764         Accumulated earnings       1,761,148       1,506,099         Deferred equity   compensation       20,177       23,528         Less treasury stock at   cost (254,736 and 297,276 shares held)       (20,177   )   (23,528   )     TOTAL   SHAREHOLDERS’ EQUITY       2,822,902       2,611,278         TOTAL LIABILITIES AND MINORITY INTEREST AND   SHAREHOLDERS’ EQUITY       $   22,001,642       $   17,081,008           The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 74     FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (in thousands)             Year Ended December 31,                 2005       2004       2003         REVENUES:                                 Net premiums written       $   577,694       $   587,769       $   614,284         Net premiums earned       $   404,059       $   395,015       $   356,373         Net investment income       200,827       172,051       154,048         Net realized gains (losses)       6,392       (473   )   5,126         Net interest income from financial products and   variable interest entities       487,916       194,675       89,133         Financial products net realized gains (losses)       (7,473   )   2,217       10,903         Net realized and unrealized gains (losses) on   derivative instruments       (172,475   )   329,259       227,449         Income from assets acquired in refinancing   transactions       35,190       31,634       25,276         Net realized gains from assets acquired in   refinancing transactions       6,508       —       —         Other income       20,291       23,891       29,370         TOTAL REVENUES       981,235       1,148,269       897,678         EXPENSES:                                 Losses and loss adjustment expenses       25,365       20,599       34,486         Interest expense       26,990       26,993       33,026         Policy acquisition costs       68,340       62,201       58,391         Financial products and variable interest entities’   foreign exchange (gain) loss       (189,785   )   91,309       118,269         Net interest expense from financial products and   variable interest entities       491,640       267,599       137,103         Other operating expenses       93,614       99,054       92,990         TOTAL EXPENSES       516,164       567,755       474,265         INCOME BEFORE   INCOME TAXES, MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED   AFFILIATES, AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE       465,071       580,514       423,413         Provision for income   taxes:                                 Current       127,479       53,472       74,619         Deferred       (606   )   57,084       19,281         Total provision       126,873       110,556       93,900         NET INCOME BEFORE   MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED AFFILIATES, AND   CUMULATIVE EFFECT OF ACCOUNTING CHANGE       338,198       469,958       329,513         Minority interest       (11,224   )   (87,408   )   (39,817   )     Equity in earnings   (losses) of unconsolidated affiliates, net of income taxes of $(2,026),   $(604) and $1,884       (866   )   (3,943   )   3,631         Cumulative effect   of accounting change, net of income taxes of $2,598       —       —       4,800         NET INCOME       326,108       378,607       298,127         OTHER   COMPREHENSIVE INCOME (LOSS), NET OF TAX:                                 Unrealized gains   (losses) arising during period (net of deferred income tax provision   (benefit) of $(25,837), $18,698 and $4,887)       (32,012   )   36,164       5,064         Less:   reclassification adjustment for gains included in net income (net of deferred   income tax provision of $6,205, $237 and $1,278)       11,523       1,017       3,758         Other   comprehensive income (loss)       (43,535   )   35,147       1,306         COMPREHENSIVE INCOME       $   282,573       $   413,754       $   299,433           The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 75     FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (in thousands)             Common   Stock       Additional   Paid-In   Capital-   Common       Unrealized   Gain   on   Investments       Accumulated   Earnings       Deferred   Equity   Compensation       Treasury   Stock       Total         BALANCE, December 31, 2002           $   335               $   903,494               $   163,311               $   852,241               $   23,445               $   (23,445   )       $   1,919,381         Net income for the year                                                           298,127                                           298,127         Net change in   accumulated other comprehensive income (net of deferred income tax expense of   $3,609)                                           1,306                                                           1,306         Capital contribution                           335                                                                           335         BALANCE, December 31, 2003           335               903,829               164,617               1,150,368               23,445               (23,445   )       2,219,149         Net income for the year                                                           378,607                                           378,607         Net change in   accumulated other comprehensive income (net of deferred income tax expense of   $18,461)                                           35,147                                                           35,147         Capital contribution                           1,251                                                                           1,251         Dividends paid on   common stock                                                            (22,876   )                                       (22,876   )     Deferred equity payout                                                                           83               (83   )       —         BALANCE, December 31, 2004            335                905,080               199,764                1,506,099               $   23,528                (23,528   )        2,611,278         Net income for the year                                                           326,108                                           326,108         Net change in   accumulated other comprehensive income (net of deferred income tax (benefit)   of $(19,632))                                           (43,535   )                                                       (43,535   )     Capital contribution                           110                                                                           110         Dividends paid on   common stock                                                            (71,059   )                                       (71,059   )     Deferred equity payout                                                                           (3,351   )           3,351           —         BALANCE, December 31,   2005           $   335               $   905,190               $   156,229               $   1,761,148               $   20,177               $   (20,177   )       $   2,822,902           The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 76     FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)             Years Ended December 31,                 2005       2004       2003         Cash flows from   operating activities:                                 Premiums received, net       $   594,390       $   571,696       $   591,030         Policy acquisition and other operating expenses paid,   net       (167,947   )   (141,875   )   (105,870   )     Recoverable advances recovered (paid)       (362   )   7,327       (959   )     Losses and loss adjustment expenses paid, net       (1,124   )   (42,936   )   (5,972   )     Net investment income received       204,460       171,915       145,221         Federal income taxes paid       (122,754   )   (62,723   )   (83,972   )     Interest paid on notes       (26,957   )   (27,789   )   (28,687   )     Interest paid on guaranteed investment contracts       (267,910   )   (71,392   )   (35,739   )     Interest received on guaranteed investment contracts   portfolio       403,511       113,030       61,069         Variable interest entities’ interest paid       (6,739   )   (3,216   )   (3,513   )     Variable interest entities’ net interest income   received       29,310       26,151       10,788         Financial products and variable interest entities’   net derivative payments       (21,016   )   (18,848   )   (12,564   )     Income received from refinanced assets       37,359       28,485       25,617         Other       (1,227   )   2,989       33,170         Net cash provided by operating activities       652,994       552,814       589,619         Cash flows from investing   activities:                                 Proceeds from sales and maturities of bonds       1,888,490       1,455,149       1,564,100         Purchases of bonds       (2,217,506   )   (1,918,477   )   (2,155,796   )     Net (increase) decrease in short-term   investments       (62,899   )   (26,074   )   93,653         Proceeds from sales and maturities of financial   products bonds       7,057,311       2,577,485       1,222,708         Purchases of financial products bonds       (11,107,956   )   (6,197,067   )   (3,385,041   )     Securities purchased under agreements to resell       (350,000   )   175,000       (85,000   )     Net (increase) decrease in financial products short-term   investments       (747,384   )   (39,310   )   (224,180   )     Purchases of variable interest entities’ bonds       —       —       (16,200   )     Maturities of variable interest entities’ bonds       183,150       66,575       —         Net (increase) decrease in variable interest entities’   short-term investments       (1,479   )   9,925       13,048         Purchases of property, plant and equipment       (32,973   )   (5,427   )   (1,202   )     Assets acquired in refinancing transactions       —       (378,672   )   (53,625   )     Paydowns of assets acquired in refinancing   transactions       92,514       102,534       51,395         Proceeds from sales of assets acquired in refinancing   transactions       182,701       60,953       —         Other investments       46,877       247       30,367         Net cash used for investing activities       (5,069,154   )   (4,117,159   )   (2,945,773   )     Cash flows from financing   activities:                                 Issuance of notes payable       —       —       96,673         Repayment of notes payable       —       —       (100,000   )     Distribution to minority shareholder       (55,443   )   (6,980   )   (3,290   )     Dividends paid       (71,059   )   (22,876   )   —         Securities sold under repurchase agreements       (5,656   )   (58,309   )   63,965         Proceeds from issuance of guaranteed investment   contracts       8,083,276       6,483,881       3,328,487         Repayment of guaranteed investment contracts       (3,545,405   )   (2,740,376   )   (1,139,173   )     Proceeds from issuance of variable interest entities’   debt       206,674       102,139       101,189         Repayment of variable interest entities’ debt       (189,230   )   (190,681   )   —         Capital issuance costs       (1,343   )   (1,260   )   (3,605   )     Capital contribution       110       —       —         Repayment of variable interest entities’ preferred   stock       —       (6,300   )   —         Net cash provided by financing activities       4,421,924       3,559,238       2,344,246         Net (decrease) increase in cash       5,764       (5,107   )   (11,908   )     Cash at beginning of year       14,353       19,460       31,368         Cash at end of year       $   20,117       $   14,353       $   19,460           The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 77     FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (in thousands)           Year Ended December 31,                 2005       2004       2003         Reconciliation of   net income to net cash flows from operating activities:                                 Net income       $   326,108       $   378,607       $   298,127         Increase in accrued investment income       (14,126   )   (15,976   )   (5,535   )     Increase in deferred premium revenue, net of prepaid   reinsurance premiums          173,635       169,670       274,010         Increase in deferred acquisition costs       (27,114   )   (34,369   )   (19,869   )     Increase (decrease) in current federal income taxes   payable       5,921       7,430       8,696         Increase (decrease) in unpaid losses and loss   adjustment expenses, net of reinsurance recoverable       24,856       (29,651   )   28,736         Increase (decrease) in amounts withheld for others       —       —       (18   )     Provision (benefit) for deferred income taxes       1,330       57,689       23,767         Net realized losses (gains) on investments       (5,427   )   (1,744   )   (16,029   )     Depreciation and accretion of discount       96,907       29,639       29,511         Minority interest and equity in earnings of   unconsolidated affiliates       14,116       90,746       34,298         Change in other assets and liabilities       56,788       (99,227   )   (66,075   )     Cash provided by   operating activities       $   652,994       $   552,814       $   589,619          On July 1, 2003, the Company consolidated $1.9 billion in assets and $1.9 billion in liabilities relating to variable interest entities with no corresponding cash movement. The Company received tax benefits of $1.2 million in 2004 and $0.3 million in 2003 from its parent company, which were recorded as capital contributions. There were no such benefits recorded in 2005. See Note 10 for disclosure of non-cash transactions relating to restricted treasury stock transactions. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 78     FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003 1.   ORGANIZATION AND OWNERSHIP Financial Security Assurance Holdings Ltd. (“FSA Holdings”, or together with its consolidated entities, the “Company”) is a holding company incorporated in the State of New York. The Company is principally engaged, through its insurance company subsidiaries, in providing financial guaranty insurance on municipal and asset-backed obligations. Its primary insurance company subsidiary is Financial Security Assurance Inc. (“FSA”). The Company’s underwriting policy is to insure municipal and asset-backed obligations that it determines would be investment-grade quality without the benefit of the Company’s insurance. Municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers’ taxing powers and special revenue bonds and other special obligations of states and local governments that are supported by the issuers’ abilities to impose and collect fees and charges for public services or specific projects. Municipal obligations include obligations backed by the cash flow from leases or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities. Asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap (“CDS”) obligations or credit-linked notes that reference pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. Financial guaranty insurance written by the Company guarantees scheduled payments on an issuer’s obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or, at its option, to pay such amounts on an accelerated basis. The Company expects to continue to emphasize a diversified insured portfolio characterized by insurance of both municipal and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company’s insured portfolio consists primarily of municipal and asset-backed obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe and the Asia Pacific region. The Company issues guaranteed investment contracts (“GICs”) through its consolidated affiliates: FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). FSACM has conducted substantially all of the Company’s GIC business since April 2003, following the receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Affiliates lend the proceeds from their sales of GICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generally in obligations that qualify for FSA insurance. The GIC Affiliates and FSAM are collectively referred to as the “FP Segment.” The Company consolidates the results of certain variable interest entities (“VIEs”), including FSA Global Funding Limited (“FSA Global”), Premier International Funding Co. (“Premier”) and Canadian Global Funding Corporation (“Canadian Global”). The Company consolidated FSA Global and Canadian Global beginning in the third quarter of 2003 in accordance with Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”). The Company also began to consolidate Premier in the third quarter of 2003 as a result of  79    obtaining control rights. The Company refinanced certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated. FSA Global is a special purpose funding vehicle owned 29% by a subsidiary of the Company. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. The majority of Canadian Global’s assets were liquidated and its liabilities satisfied during the third quarter of 2004. Premier is principally engaged in debt defeasance for lease transactions. The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. Substantially all of FSA Global’s assets are pledged as collateral to secure the repayment, on a pro rata basis, of FSA Global’s debt. On July 5, 2000, the Company completed a merger in which Financial Security Assurance Holdings Ltd. (“FSA Holdings”) became a direct subsidiary of Dexia Holdings, Inc. (“Dexia Holdings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”), a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets, as well as on the Luxembourg Stock Exchange. Dexia Crédit Local is a wholly owned subsidiary of Dexia. At December 31, 2005, Dexia Holdings owned approximately 99% of the Company’s outstanding shares; the only other holders of the Company’s common stock were an affiliate of White Mountains Insurance Group, Ltd. (“White Mountains”) and certain directors of the Company who owned shares of the Company’s common stock or economic interests therein under the Director Share Purchase Program (see Note 10). 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which, for the insurance company subsidiaries, differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). 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 in the Company’s consolidated balance sheets at December 31, 2005 and 2004, the reported amounts of revenues and expenses in the statements of operations and comprehensive income during the years ended December 31, 2005, 2004 and 2003 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows: Basis of Presentation The Consolidated Financial Statements include the accounts of FSA Holdings and its direct and indirect subsidiaries, principally including FSA, FSA Insurance Company, Financial Security Assurance International Ltd. (“FSA International”), Financial Security Assurance (U.K.) Limited, the GIC Affiliates, FSAM, FSA Portfolio Management Inc., Transaction Services Corporation, FSA Services (Australia) Pty Limited and FSA Services (Japan) Inc. (collectively, the “Subsidiaries”). The Consolidated Financial Statements also include the accounts of certain VIEs as described in Note 1. All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the current-year presentation. 80    Investments Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged or are economically hedged but do not qualify for hedge accounting  is reflected as a separate component of shareholders’ equity, net of applicable deferred income taxes. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in income currently. Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at cost, which approximates fair value. Amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less and are included in short-term investments. Variable-rate demand notes (“VRDN”) and auction-rate securities (“ARS”) are included in bonds and financial products bond portfolio at fair value. VRDNs are long-term bonds that bear floating interest rates and provide investors with the option to tender or put the bonds at par, generally on a daily, weekly or monthly basis. ARS are long-term securities with interest-rate reset features and are traded in the marketplace through a bidding process. The cash flows related to these securities are presented on a gross basis in the consolidated statements of cash flows. Mortgage loans are carried at the lower of cost or market on an aggregate basis. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. Other-than-temporary impairments are reflected in earnings as a realized loss. Investments in unconsolidated affiliates are based on the equity method of accounting (see Note 18). The Company records its share of unrealized gains or losses of unconsolidated affiliates, net of applicable deferred taxes, in other comprehensive income. Derivatives The Company enters into derivative contracts to manage interest-rate and foreign currency exposure of the Company’s GIC and VIE debt, GIC bond portfolio and VIE bond portfolio. The derivatives are recorded at fair value. These derivatives generally include interest-rate futures and interest rate and currency swap agreements, which are primarily utilized to convert the Company’s fixed-rate obligations on its GIC and VIE debt, GIC bond portfolio and VIE bond portfolio into U.S.-dollar floating-rate obligations. The gains and losses relating to the fair value of derivatives are included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income. The gains and losses related to derivatives designated as fair-value hedges are included in net interest income from financial products and variable interest entities and net interest expense from financial products and variable interest entities, as appropriate, along with the offsetting change in the fair value of the risk being hedged. The Company has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred.  81    Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities, as appropriate. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates of fair value. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company’s valuation process may differ materially from values that may be realized in market transactions. Securities Purchased under Agreements to Resell and Securities Sold under Agreements to Repurchase Securities purchased under agreements to resell and securities sold under agreements to repurchase are accounted for as collateralized transactions and are recorded at contract value plus accrued interest, subject to the provisions of Statement of Financial Accounting Standards No. 140, “Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities.” It is the Company’s policy to take possession of securities borrowed under agreements to resell. Premium Revenue Recognition Gross and ceded premiums received in upfront payouts are earned in proportion to the expiration of the related risk. For upfront premium transactions, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portion of gross and ceded premium, respectively, that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. For premiums received on an installment basis, the Company earns the premium over each installment period, typically less than one year, throughout the period of coverage. Typically, installment premiums are applicable to insured transactions that involve CDS or special purpose vehicles (“SPVs”) structured to finance pools of assets such as auto loans or mortgage loans. Premiums on such transactions are typically paid in installments because premium is paid from the interest spread available to the SPV (i.e. the difference in interest rate between the yield on its assets and the yield on its liabilities). The nature of the assets financed can have uncertain debt service schedules due to prepayments. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions. Losses and Loss Adjustment Expenses Background Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Upon a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or, at its option, to pay such amounts on an accelerated basis. The financial guaranty industry has emerged over the past thirty-four years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing  82    literature, including sections of SFAS 60, Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognition of fees for guaranteeing a loan” (“EITF 85-20”). Company-specific policy The Company establishes loss liabilities based on its estimate of specific and non-specific losses. The Company also establishes liabilities for loss adjustment expenses (“LAE”), consisting of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process. The Company calculates a loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated. Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an auto accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made. The Company establishes a case reserve for the present value of the estimated loss, net of subrogation recoveries, when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and reasonably estimable at the balance sheet date. When an insured obligation has met the criteria for establishing a case reserve and that transaction pays a premium in installments, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue. A case reserve is determined using cash flow or similar models that represent the Company’s estimate of the net present value of the anticipated shortfall between (1) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (2) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. The estimated loss, net of recovery, on a transaction is discounted using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established and is not subsequently adjusted. The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. The non-specific and case reserves together represent the Company’s estimate of total reserves. Generally, when an insured credit deteriorates to a point where claims are expected, a case reserve is established. The establishment of a non-specific reserve for credits that have not yet defaulted is a common practice in the financial guaranty industry, although there are differences in the specific methodologies applied by other financial guarantors in establishing and measuring these reserves. The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as rating agency publications. The establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Ratings Services  83    (“S&P”), together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor that is updated and applied to current-year originations. The process results in management’s best estimate of inherent losses associated with providing credit protection at each balance sheet date. The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the “statistical calculation”). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody’s and severity factors obtained from S&P. Moody’s is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody’s default information is applied to all credit sectors or asset classes as described below. In its publication of default rates from 1970-2004, Moody’s tracks bonds over a twenty-year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company’s methodology segregates the portfolio into asset classes, including health care transactions, all other municipal transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis. The product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The experience factor is based on the Company’s inception-to-date historical losses (starting from 1993, when the Company established the non-specific reserve methodology). The experience factor is calculated by dividing cumulative inception-to-date actual losses incurred by the Company by the cumulative inception-to-date losses determined by the statistical calculation. The experience factor that applies to the whole portfolio is reviewed and, where appropriate, updated periodically, but no less than annually. The present value of loss amounts calculated for the current-year originations is established at inception of the policy, and there is no subsequent change unless significant adverse or favorable loss experience is observed. In the event that the experience factor is either increased or decreased based on adverse or favorable loss experience, an analysis is performed of the non-specific reserve balance with particular emphasis on the asset class, if any, driving the experience factor adjustment. The objective of such analysis is to quantify the appropriate adjustment to the overall non-specific reserve balance for the change in experience. The adjustment that increases or decreases the non-specific reserve is charged or credited to loss expense. The present value of loss amounts calculated for the current-year originations plus an amount representing the accretion of discount pertaining to prior-year originations are charged to loss expense and increase the non-specific loss reserve after adjustments that may be made to reflect observed favorable or adverse experience. The entire non-specific reserve is available to absorb probable losses inherent in the portfolio. As there are no specific losses provided in the non-specific reserve, there is no identifiable reinsurance recoverable. At the time that a case reserve is identified, the gross loss liability is recognized along with the reinsurance recoverable, if any. The amount of reinsurance recoverable depends on the policy ceded and the reinsurance agreements covering such policy. Management cannot predict the specific policies that will emerge as case-basis losses from the portfolio and is not entitled to recovery from the reinsurer in advance of producing a case reserve. 84    Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually based on a review of the Company’s inception-to-date cumulative losses divided by the total inception-to-date cumulative net par underwritten. This inception-to-date result is compared with the product of the non-specific reserves divided by the net par outstanding as of the balance sheet date. In the event that such ratios are not in line, then further analysis is performed to quantify appropriate adjustments that may be either charges or benefits on the consolidated statements of operations and comprehensive income, as occurred in 2003, 2004 and 2005. The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves.             As of December 31,                 2005       2004         Case reserve   discount rate       3.13%–5.90%       3.13%–5.90%         Non-specific   reserve discount rate       1.20%–7.95%       1.20%–7.95%         Current experience   factor       1.8       2.0           Reserving Methodology Industry Practice Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time. Management believes that existing accounting literature does not address the unique attributes of financial guaranty insurance. As an insurance enterprise, the Company initially refers to the accounting and financial reporting guidance in SFAS 60. In establishing loss liabilities, the Company relies principally on SFAS 60, which prescribes differing treatment depending on whether a contract is a short-duration contract or a long-duration contract. Financial guaranty insurance does not fall clearly within the definition of either short-duration or long-duration contracts. Therefore, the Company does not believe that SFAS 60 alone provides sufficient guidance for financial guaranty claim liability recognition. As a result, the Company also analogizes to SFAS 5, which requires the establishment of liabilities when a loss is both probable and reasonably estimable. The Company also relies by analogy on EITF 85-20, which provides general guidance on the recognition of losses related to guaranteeing a loan. In the absence of a comprehensive accounting model provided by SFAS 60, industry participants, including the Company, have looked to such other guidance referred to above to develop their accounting policies for the establishment and measurement of loss liabilities. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that a portfolio of credit-based insurance, comprising irrevocable contracts that cannot be unilaterally changed by the insurer and that match the maturity terms of the underlying insured obligation, contains probable and reasonably estimable losses. In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with financial guaranty industry participants, differences in loss recognition practices among those participants. Based on discussions with the SEC staff, the Company understands that the Financial Accounting Standards Board (“FASB”) staff is considering additional guidance regarding financial  85    guaranty insurance. When and if the FASB or SEC reach a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, and the potential changes could extend to premium and expense recognition. The Company cannot predict how the FASB or SEC will resolve this issue and the resulting impact on its financial statements. Until additional guidance is issued, the Company intends to continue applying its existing policy regarding the establishment of both case and non-specific loss reserves. Deferred Acquisition Costs Deferred acquisition costs are comprised of expenses related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission received on premiums ceded to reinsurers. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums. The Company does not defer acquisition costs relating to GICs issued by the GIC Affiliates, except for GIC commissions paid to third parties, which are included in other assets. The amortization of these commissions is recorded in net interest expense from financial products and VIEs. GIC and VIE Debt GIC and VIE debt is recorded at amortized cost. The Company may enter into associated transactions in order to reduce the Company’s exposure to fluctuations in interest and foreign exchange rates and its related effect on the fair value of the debt. The change in the fair value of the hedged item in a qualifying accounting hedge attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, embedded derivatives are required to be separated from the debt instrument and accounted for at fair value, with all changes reflected through earnings. Foreign Currency Translation Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year. Unrealized gains and losses on available-for-sale securities, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders’ equity. Gains and losses from transactions in foreign currencies are recorded in income. Federal Income Taxes The provision for income taxes consists of an amount for taxes currently payable and a provision for the deferred tax consequences of temporary differences between the tax basis of assets and liabilities and the financial statement basis. Non-interest-bearing tax and loss bonds are purchased to prepay 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 other assets. 86     Assets Acquired in Refinancing Transactions Asset-backed senior notes represent the Company’s purchase of less than 50% of a refinanced transaction. Asset-backed senior notes are carried at cost, with any reduction in carrying value recognized as an adjustment to yield. 3.   INVESTMENTS In addition to its insurance company and certain non-insurance subsidiaries’ investments (the “Investment Portfolio”), the Company maintains investments from proceeds of FSA-insured GICs (the “FP Investment Portfolio”) and investments in the portfolio of securities owned by the VIEs (the “VIE Portfolio”) and assets acquired in refinancing transactions (see Note 22). Investment Portfolio Bonds and short-term deposits at amortized cost of $9.9 million and $9.7 million at December 31, 2005 and 2004, respectively, were on deposit with state regulatory authorities as required by insurance regulations. Consolidated net investment income attributable to the Investment Portfolio consisted of the following (in thousands):             Year Ended December 31,                 2005       2004       2003         Bonds and   short-term investments       $   194,736       $   174,551       $   156,729         Equity   investments       8,931       —       —         Investment   expenses       (2,840   )   (2,500   )   (2,681   )     Net investment income       $   200,827       $   172,051       $   154,048           The credit quality of bonds in the Investment Portfolio at December 31, 2005 was as follows:     Rating(1)               Percent of Bonds         AAA           78.6   %         AA           17.4             A            4.0                         100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. Of the bonds included in the Investment Portfolio, 6.8% were Triple-A by virtue of insurance provided by FSA (“FSA-Insured Investments”). Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments, which is the rating without giving effect to the FSA insurance, was in the Double-A range. 87    The amortized cost and fair value of the bonds in the Investment Portfolio were as follows (in thousands):             As of December 31, 2005                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         U.S. Treasury securities and obligations of U.S.   government corporations and agencies       $   195,495           $   3,881               $   (755   )       $   198,621         Obligations of   states and political subdivisions       3,431,046           173,279               (5,457   )       3,598,868         Mortgage-backed   securities       250,001           809               (4,564   )       246,246         Corporate   securities       186,369           1,797               (2,124   )       186,042         Foreign   securities       116,217           1,260               (5,191   )       112,286         Asset-backed   securities       40,216           10               (252   )       39,974         Subtotal       4,219,344           181,036               (18,343   )       4,382,037         Short-term   investments       182,645           —               —           182,645         Total       $   4,401,989           $   181,036               $   (18,343   )       $   4,564,682                       As of December 31, 2004                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         U.S. Treasury securities and obligations of U.S.   government corporations and agencies       $   164,312           $   5,347               $   (356   )       $   169,303         Obligations of   states and political subdivisions       3,058,967           220,875               (1,987   )       3,277,855         Mortgage-backed   securities       220,202           3,630               (1,322   )       222,510         Corporate   securities       237,486           7,075               (505   )       244,056         Foreign   securities       126,099           19,895               (714   )       145,280         Asset-backed   securities       56,843           312               (71   )       57,084         Subtotal       3,863,909           257,134               (4,955   )       4,116,088         Short-term   investments       119,746           —               —           119,746         Total       $   3,983,655           $   257,134               $   (4,955   )       $   4,235,834           The following table shows the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position (in thousands):             As of December 31, 2005                 Less than 12 Months       12 Months or More       Total                 Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses         U.S. Treasury securities and obligations of U.S.   government corporations and agencies       $   65,922           $   (436   )       $   14,635           $   (319   )       $   80,557           $   (755   )         Obligations of states and political subdivisions       375,766           (3,609   )       108,031           (1,848   )       483,797           (5,457   )         Mortgage-backed securities       141,687           (2,272   )       48,060           (2,292   )       189,747           (4,564   )         Corporate securities       103,144           (1,492   )       23,650           (632   )       126,794           (2,124   )         Foreign securities       37,480           (5,181   )       1,508           (10   )       38,988           (5,191   )         Asset-backed securities       18,540           (124   )       14,813           (128   )       33,353           (252   )         Total       $   742,539           $   (13,114   )       $   210,697           $   (5,229   )       $   953,236           $   (18,343   )             88                  As of December 31, 2004                 Less than 12 Months       12 Months or More       Total                 Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses         U.S. Treasury securities and obligations of U.S.   government corporations and agencies       $   60,259           $   (192   )       $   4,189           $   (164   )       $   64,448           $   (356   )         Obligations of states and political subdivisions       214,194           (1,266   )       67,095           (721   )       281,289           (1,987   )         Mortgage-backed securities       32,701           (304   )       38,784           (1,018   )       71,485           (1,322   )         Corporate securities       29,146           (162   )       17,859           (343   )       47,005           (505   )         Foreign securities       1,722           (39   )       40,136           (675   )       41,858           (714   )         Asset-backed securities       16,279           (71   )       —           —           16,279           (71   )         Total       $   354,301           $   (2,034   )       $   168,063           $   (2,921   )       $   522,364           $   (4,955   )           The Company periodically monitors its Investment Portfolio for individual investments in an unrealized loss position in order to assess whether any investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were 96 securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the 96 securities had an unrealized loss that exceeded book value by 11% at December 31, 2005. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired. The amortized cost and fair value of bonds in the Investment Portfolio at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized   Cost       Fair Value         Due in one year   or less       $   274,955       $   275,017         Due after one   year through five years       1,188,212       1,248,314         Due after five   years through ten years       670,694       701,085         Due after ten   years       1,977,911       2,054,046         Mortgage-backed   securities (stated maturities of 1 to 30 years)       250,001       246,246         Asset-backed   securities (stated maturities of 2 to 29 years)       40,216       39,974         Total       $   4,401,989       $   4,564,682           Proceeds from sales of bonds for the Investment Portfolio during 2005, 2004 and 2003 were $1,757.6 million, $1,187.3 million and $1,121.0 million, respectively. Proceeds from maturities of bonds for the Investment Portfolio during 2005, 2004 and 2003 were $130.9 million, $267.8 million and $443.1 million. Gross gains of $10.9 million, $5.2 million and $12.6 million and gross losses of $6.1 million, $5.7 million and $7.5 million were realized on sales in 2005, 2004 and 2003, respectively.   89     FP Investment Portfolio Net investment income for the FP Investment Portfolio consisted of the following (in thousands):             Year Ended December 31,                 2005       2004       2003         Bonds       $   391,125       $   137,548       $   59,271         Short-term   investments       29,639       3,499       4,430         Net investment income       $   420,764       $   141,047       $   63,701           The credit quality of bonds held in the FP Investment Portfolio at December 31, 2005 was as follows:     Rating(1)               Percent of Bonds         AAA           92.1   %         AA           6.5             A            1.4             Total           100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. Of the bonds included in the FP Investment Portfolio, 7.0% were Triple-A by virtue of insurance provided by FSA. Over 90% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Single-A range. The amortized cost and fair value of bonds held in the FP Investment Portfolio were as follows (in thousands):     December 31, 2005               Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Obligations of   U.S. states and political subdivisions       $   985,559           $   55,595               $   (684   )       $   1,040,470         Mortgage-backed   securities       2,821,562           8,994               (1,071   )       2,829,485         Corporate   securities       —           —               —           —         Asset-backed   and other securities       7,947,209           13,387               (2,727   )       7,957,869         Subtotal       11,754,330           77,976               (4,482   )       11,827,824         Short-term   investments       1,015,509           —               —           1,015,509         Total       $   12,769,839           $   77,976               $   (4,482   )       $   12,843,333               December 31, 2004               Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Obligations of U.S. states and political   subdivisions       $   712,667           $   29,702               $   (2,957   )       $   739,412         Mortgage-backed securities       2,137,814           12,377               (678   )       2,149,513         Corporate securities       8,719           36               —           8,755         Asset-backed and other securities       5,029,447           5,770               (1,912   )       5,033,305         Subtotal       7,888,647           47,885               (5,547   )       7,930,985         Short-term investments       268,125           —               —           268,125         Total       $   8,156,772           $   47,885               $   (5,547   )       $   8,199,110           90    The following table shows the gross unrealized losses and fair value for the FP Investment Portfolio, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 (in thousands):             As of December 31, 2005                 Less than 12 Months       12 Months or More       Total                 Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses         Obligations of   U.S. states and political subdivisions       $   39,163           $   (207   )       $   35,523           $   (477   )       $   74,686           $   (684   )         Mortgage-backed   securities       779,147           (1,068   )       5,993           (3   )       785,140           (1,071   )         Corporate   securities       —           —           —           —           —           —             Asset-backed   securities       912,314           (2,375   )       158,116           (352   )       1,070,430           (2,727   )         Total       $   1,730,624           $   (3,650   )       $   199,632           $   (832   )       $   1,930,256           $   (4,482   )                     As of December 31, 2004                 Less than 12 Months       12 Months or More       Total                 Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses       Fair Value       Unrealized   Losses         Obligations of U.S. states and political   subdivisions       $   15,372           $   (306   )       $   63,661           $   (2,651   )       $   79,033           $   (2,957   )         Mortgage-backed securities       453,067           (665   )       66,130           (13   )       519,197           (678   )         Corporate securities       —           —           —           —           —           —             Asset-backed securities       848,847           (1,179   )       236,573           (733   )       1,085,420           (1,912   )         Total       $   1,317,286           $   (2,150   )       $   366,364           $   (3,397   )       $   1,683,650           $   (5,547   )                                            The Company periodically monitors the FP Investment Portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were 22 securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the 22 securities had an unrealized loss that exceeded book value by 3% at December 31, 2005. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired. The amortized cost and fair value of the FP Investment Portfolio, at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized   Cost       Fair Value         Due in one year   or less       $   1,037,032       $   1,037,032         Due after five   years through ten years       19,802       19,720         Due after ten   years       944,234       999,227         Mortgage-backed   securities (stated maturities of 8 to 30 years)       2,821,562       2,829,485         Asset-backed   and other securities (stated maturities of 1 to 45 years)       7,947,209       7,957,869         Total       $   12,769,839       $   12,843,333           Proceeds from sales of bonds held in the FP Investment Portfolio during 2005, 2004 and 2003 were $293.0 million, $91.7 million and $190.7 million, respectively. Proceeds from maturities of bonds for the FP Investment Portfolio during 2005, 2004 and 2003 were $6,764.3 million, $2,485.8 million and $1,032.0 million. Gross gains of $0.4 million and gross losses of $7.9 million were realized on sales in 2005. Gross gains of $2.2 million were realized on sales in 2004. Gross gains of $10.9 million were realized on sales in 2003. 91    4.   DEFERRED ACQUISITION COSTS Acquisition costs deferred for amortization against future income and the related amortization charged to expenses are as follows (in thousands):             Year Ended December 31,                 2005       2004       2003         Balance, beginning of period       $   308,015       $   273,646       $   253,777         Costs deferred   during the period:                                 Ceding commission   income, net       (63,174   )   (65,838   )   (73,943   )     Premium taxes       20,894       16,551       16,773         Compensation and other   acquisition costs       137,734       145,857       135,430         Total       95,454       96,570       78,260         Costs amortized during the period       (68,340   )   (62,201   )   (58,391   )     Balance, end of   period       $   335,129       $   308,015       $   273,646           5.   STATUTORY ACCOUNTING PRACTICES GAAP differs in certain significant respects from statutory accounting practices, applicable to insurance companies, that are prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices: ·       upfront premiums are recognized as earned when related principal and interest have expired rather than over the expected coverage period; ·       acquisition costs are charged to operations as incurred rather than as related premiums are earned; ·       a contingency reserve (rather than a non-specific reserve) is computed based on the following statutory requirements: 1)               for all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions, plus 2)               for all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either 1/60th or 1/80th of the total required for each category, less permitted reductions; ·       certain assets designated as “non-admitted assets” are charged directly to statutory surplus but are reflected as assets under GAAP; ·       deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carry back; ·       insured CDS are considered to be insurance contracts, not derivative contracts recorded at fair value; ·       bonds are carried at amortized cost; ·       VIEs and refinancing vehicles are not consolidated under statutory accounting standards; ·       surplus notes are recognized as surplus rather than as a liability unless approved for repayment; and ·       non-insurance company subsidiaries do not prepare accounts applying statutory accounting standards. 92    Reconciliations of net income for the years ended 2005, 2004 and 2003 and shareholders’ equity at December 31, 2005 and 2004, reported by the Company on a GAAP basis, to the amounts reported by the insurance company subsidiaries on a statutory basis, are as follows (in thousands):             Year Ended December 31,         Net Income:               2005       2004       2003         FSA Holdings consolidated GAAP net income       $   326,108       $   378,607       $   298,127         Equity in earnings of FSA Holdings consolidated   subsidiaries       25,870       (11,319   )   25,479         FSA consolidated GAAP net income       351,978       367,288       323,606         Deferral of net acquisition costs       (95,454   )   (96,571   )   (78,259   )     Amortization of acquisition costs       68,340       62,202       58,391         Fair-value adjustment for derivatives       (9,836   )   (54,182   )   (35,091   )     Loss expense       17,276       3,889       21,813         Consolidation of assets acquired in refinancing   transactions       (10,207   )   (6,771   )   (335   )     Deferred income tax       17,335       63,465       11,364         Current income tax       (2,416   )   (18,706   )   (18,048   )     Earned premium       (44,388   )   (74,707   )   (25,178   )     Other       342       (3,826   )   4,681         FSA consolidated   statutory net income       $   292,970       $   242,081       $   262,944                                      As of December 31,         Shareholders’ Equity:               2005       2004         FSA Holdings consolidated GAAP Equity       $   2,822,902       $   2,611,278         Equity in earnings of FSA Holdings consolidated   subsidiaries       79,524       85,957         FSA consolidated GAAP Equity       2,902,426       2,697,235         Deferred acquisition costs       (335,129   )   (308,015   )     Fair-value of derivatives       (56,811   )   (47,343   )     Loss reserves       115,162       96,381         Contingency reserves       (906,841   )   (1,099,462   )     Unrealized gain on investments       (174,878   )   (240,895   )     Consolidation of assets acquired in refinancing   transactions        248       (1,960   )     Surplus notes       93,850       74,299         Deferred income taxes       263,206       275,323         Deferred premium revenue       (335,037   )   (307,173   )     Other       (55,521   )   43,031         FSA statutory surplus       1,510,675       1,181,421         Statutory surplus   plus contingency reserve       $   2,417,516       $   2,280,883                       6.   FEDERAL INCOME TAXES Dexia Holdings and the Company and its Subsidiaries, except FSA International, file a consolidated federal income tax return. A tax-sharing agreement between them provides that each member’s tax benefit or expense is calculated on a separate-return basis and that any credits or losses available to the Company are allocated among the members based on each member’s taxable income. At December 31, 2004, the Company and its Subsidiaries received benefits from utilizing Dexia Holdings’ credits and losses of $1.3 million. The Company and its Subsidiaries did not receive any such benefits in 2005. These amounts  93    have been recorded as capital contributions and reductions in amounts payable to Dexia Holdings in the financial statements. Except as described below, federal income taxes were not provided on all of the undistributed earnings of FSA International, since it was the Company’s practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $22.6 million and $86.7 million at December 31, 2004 and 2003, respectively. The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005. In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%). In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore. As a result, FSA International is subject to an increased effective U.S. tax rate on its 2005 and future income. The impact on earnings reflects (1) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax purposes and (2) $14.2 million related to 2005 earnings. Following a change in SPS’s investors in 2002, the Company determined that it would be appropriate to apply the 80% dividend-received deduction allowed by the Internal Revenue Service when accounting for the tax on its equity earnings from SPS, based on management’s expectation that it would realize its gain on such investment through dividend distributions rather than through sale of its investment. For 2004 and 2003, equity in earnings from SPS was taxed at an effective rate of 7.0%. In the first quarter of 2005, due to the pending sale of its investment in SPS Holding Corp. (“SPS”) (formerly, Fairbanks Capital Holding Corp.), the Company eliminated the assumption that accumulated earnings of SPS would be distributed in the form of dividends eligible for a dividend-received deduction. The net effect of this was to provide additional taxes on SPS’s accumulated earnings of approximately $1.6 million. In connection with Dexia’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2005. 94     The cumulative balance sheet effects of deferred federal tax consequences are as follows (in thousands):             As of December 31,                 2005       2004         Deferred   acquisition costs       $   104,335       $   95,736         Deferred premium   revenue adjustments       36,302       37,826         Unrealized   capital gains       84,058       104,604         Contingency   reserves       114,166       113,507         Undistributed   earnings       16,613       9,274         Derivative fair-value   adjustments       29,946       50,426         Other       8,212       9,185         Total deferred federal income tax liabilities       393,632       420,558         Loss and loss   adjustment expense reserves       (41,533   )   (35,540   )     Deferred   compensation       (90,866   )   (93,083   )     White Mountains   indemnity payment       (16,450   )   (16,450   )     Foreign currency   transaction loss       (7,781   )   (24,264   )     Other       (5,737   )   (1,556   )     Total deferred federal income tax assets       (162,367   )   (170,893   )     Net deferred federal   income tax liability       $   231,265       $   249,665           Management believes it is more likely than not that the tax benefit of the deferred tax assets will be realized. Accordingly, no valuation allowance was necessary at December 31, 2005 or 2004. A reconciliation of the effective tax rate with the federal statutory rate follows:             Year Ended December 31,                   2005           2004           2003           Tax at statutory rate           35.0   %           35.0   %           35.0   %         Tax-exempt investments           (9.8   )           (7.1   )           (8.3   )         Income of foreign subsidiary           2.7               (1.2   )           (1.7   )         White Mountain indemnity payment           —               (2.8   )           —             Minority interest and equity in unconsolidated   subsidiaries           (0.8   )           (4.9   )           (2.9   )         Other           0.2               —               0.1             Provision for   income taxes           27.3   %           19.0   %           22.2   %           7.   DIVIDENDS AND CAPITAL REQUIREMENTS FSA’s ability to pay dividends depends on FSA’s financial condition, results of operations, cash requirements, rating agency capital adequacy and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the Superintendent of Insurance of the State of New York or (b) adjusted net investment income during this period. FSA paid $87.0 million of dividends in 2005 and $30.0 million in 2004. Based upon FSA’s statutory statements for December 31, 2005, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $153.8 million. 95    8.   CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES FSA has a credit arrangement aggregating $150.0 million that is provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At December 31, 2005, there were no borrowings under this arrangement, which expires on April 21, 2006, if not extended. FSA has a standby line of credit commitment in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,220.0 million at December 31, 2005. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2005. FSAM has a $100.0 million line of credit with UBS Loan Finance LLC, which expires December 8, 2006, unless extended. This line of credit provides an additional source of liquidity should there be unexpected draws on GICs issued by the GIC Affiliates. There were no borrowings under this agreement at December 31, 2005. Borrowings under this agreement are conditioned on FSA having a Triple-A rating by either S&P or Moody’s, and on neither S&P nor Moody’s having issued a rating to FSA below AA+ or Aa1, respectively. In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA 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 FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million and $1.3 million for 2005 and 2004, respectively, and was recorded within other operating expenses. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts because it does not retain the majority of the residual benefits or expected losses. 9.   LONG-TERM DEBT On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the notes. In September 2003, the Company called for redemption, on November 1, 2003, $100.0 million of its 6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.95% Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the 6.95% Senior QUIDS were charged to interest expense in 2003. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS. On November 26, 2002, the Company issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. 96    On December 19, 2001, the Company issued $100.0 million of 67¤8% Quarterly Income Bond Securities due December 15, 2101, which are callable without premium or penalty on or after December 19, 2006. Debt issuance costs of $3.3 million are being amortized over the life of the debt. 10.   EMPLOYEE BENEFIT PLANS The Company maintains both qualified and non-qualified, non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $7.0 million, $5.8 million and $4.9 million for the years ended December 31, 2005, 2004 and 2003, respectively. The Company has an employee retirement savings plan for the benefit of eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by Internal Revenue Code Section 401(k). Contributions by the Company are discretionary, and none have been made. Through 2004, performance shares were awarded under the 1993 Equity Participation Plan (the “1993 Equity Plan”). The 1993 Equity Plan authorized the discretionary grant of performance shares by the Human Resources Committee to key employees. The amount earned for each performance share depends on the attainment of certain growth rates of adjusted book value and book value per outstanding share over a three-year period. Performance shares issued prior to January 1, 2005 permitted the participant to elect, at the time of award, growth rates including or excluding realized and unrealized gains and losses on the Investment Portfolio. Performance shares issued after January 1, 2005 do not offer the option to include the impact of unrealized gains and losses on the Investment Portfolio. No payout occurs if the compound annual growth rate of adjusted book value and book value per outstanding share over specified three-year performance cycles is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%. In 2004, the Company adopted the 2004 Equity Participation Plan (the “2004 Equity Plan”), which continues the incentive compensation program formerly provided under the Company’s 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Company’s performance over specified three-year performance cycles as described above) and 10% of shares of Dexia restricted stock. The Dexia restricted stock component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid, which is amortized over 2.5-year and 3.5-year vesting periods. In the first quarter of 2005, FSA purchased shares to economically defease its liability for $4.4 million. This amount is being amortized to expense over the employees’ vesting periods. Performance shares granted under the 1993 Equity Plan and 2004 Equity Plan are as follows:             Outstanding   at   Beginning of   Year       Granted   During   the Year       Paid out   During   the Year       Forfeited   During the   Year       Outstanding   at   End of Year       Price per   Share   at Grant   Date         2003           1,415,826           342,845       464,778           13,261               1,280,632           $   92.72         2004           1,280,632           349,506       398,292           20,038               1,211,808           109.71         2005           1,211,808           330,957       313,987           24,434               1,204,344           131.30                                  The estimated final cost of these performance shares is accrued over the performance period. The expense for the performance shares was $55.8 million, $73.3 million and $63.1 million for the years ended December 31, 2005, 2004 and 2003, respectively. 97    Awards of Dexia restricted stock remain restricted for an additional six months after the end of the vesting periods. In 2005, the Company awarded 194,202 Dexia restricted shares valued at $22.69 on the award date. As of December 31, 2005, 5,150 shares had been forfeited and 8,756 shares had vested. 11.   COMMITMENTS AND CONTINGENCIES Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York, to be used as the Company’s new headquarters. The Company moved to this new space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building’s operating expenses. The lease also contains a renewal option for an additional ten-year period and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition, the Company and its Subsidiaries lease additional office space under non-cancelable operating leases, which expire at various dates through 2013. Future minimum rental payments are as follows (in thousands):     Year Ended December 31,                         2006       $   7,141.6         2007       8,263.6         2008       8,217.3         2009       8,204.7         2010       8,141.2         Thereafter       119,848.4         Total       $   159,816.8           Rent expense was $10.1 million in 2005, $7.8 million in 2004 and $7.3 million in 2003. Rent expense in 2005 includes a $1.2 million lease termination fee related to the Company’s former headquarters. During the ordinary course of business, the Company and its Subsidiaries become parties to certain litigation. The Company is not subject to any material pending legal proceedings. 12.   REINSURANCE The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated (see Note 14) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis. In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company would be unable to recover such defaulted amounts. Certain of the reinsuring companies have provided collateral to secure their reinsurance obligations. 98    Amounts of ceded and assumed business were as follows (in thousands):             Year Ended December 31,                 2005       2004       2003         Written premiums ceded       $   256,087       $   244,211       $   281,542         Written premiums assumed       9,474       11,567       3,294         Earned premiums ceded       150,087       161,733       159,350         Earned premiums assumed       3,521       6,608       3,832         Losses and loss adjustment expense payments ceded       1,465       52,372       16,993         Losses and loss   adjustment expense payments assumed       8       16       —                                    As of December 31,                 2005       2004         Principal   outstanding ceded       $   120,607,468       $   116,687,760         Principal   outstanding assumed       2,597,375       2,134,427         Deferred premium   revenue ceded       865,192       759,191         Deferred premium   revenue assumed       23,777       17,823         Losses and loss   adjustment expense reserves ceded       36,339       35,419         Losses and loss   adjustment expense reserves assumed       643       553                     13.   OUTSTANDING EXPOSURE AND COLLATERAL The Company’s policies insure the scheduled payments of principal and interest on municipal and asset-backed (including FSA-insured CDS) obligations. The gross amount of financial guarantees in force (principal and interest) was $668.2 billion at December 31, 2005 and $622.6 billion at December 31, 2004. The net amount of financial guarantees in force was $480.2 billion at December 31, 2005 and $444.5 billion at December 31, 2004. The net par outstanding as of December 31, 2005 and 2004 and the contractual terms to maturity are as follows (in millions):             As of December 31, 2005       As of December 31, 2004         Terms to Maturity(1)               Municipal       Asset-Backed(2)       Municipal       Asset-Backed(2)         0 to 5 years       $   44,272           $   41,997           $   39,448           $   46,800             5 to 10 years       49,935           31,354           43,165           29,155             10 to 15 years       44,392           12,180           37,174           10,772             15 to 20 years       36,737           744           30,857           1,084             20 years and   above       51,724           24,148           44,748           34,539             Total       $   227,060           $   110,423           $   195,392           $   122,350                                    (1)          Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. (2)          Excludes intercompany insurance of $13,463 million in 2005 and $7,143 million in 2004 relating to FSA-insured GICs issued by the GIC Affiliates. 99    The par amount ceded as of December 31, 2005 and 2004 and the terms to maturity are as follows (in millions):             As of December 31, 2005       As of December 31, 2004         Terms to Maturity(1)               Municipal       Asset-Backed(2)       Municipal       Asset-Backed(2)         0 to 5 years           $   12,950               $   16,180               $   11,443               $   21,662             5 to 10 years           16,332               7,011               14,707               6,909             10 to 15 years           16,954               1,477               14,630               2,228             15 to 20 years           15,180               1,474               12,870               1,373             20 years and above           29,048               4,001               26,004               4,862             Total           $   90,464               $   30,143               $   79,654               $   37,034                                         The net par outstanding of insured obligations in the municipal insured portfolio includes the following amounts by type of issue (in millions):             Net Par Outstanding   as of December 31,       Ceded   as of December 31,         Types of Issues               2005       2004       2005       2004         General   obligation bonds       $   91,338       $   77,865       $   26,295       $   24,278         Housing revenue   bonds       7,585       7,628       2,153       2,224         Municipal utility   revenue bonds       36,794       33,544       13,999       13,761         Health care   revenue bonds       11,789       9,261       8,889       7,784         Tax-supported   non-general obligation bonds       40,622       36,631       16,776       14,564         Transportation   revenue bonds       14,695       12,834       8,944       7,584         Other municipal   bonds       24,237       17,629       13,408       9,459         Total municipal   obligations       $   227,060       $   195,392       $   90,464       $   79,654                             The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on asset-backed obligations, as well as through reinsurance. The net par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral (in millions):             Net Par Outstanding(1)   as of December 31,       Ceded   as of December 31,         Types of Collateral               2005       2004       2005       2004         Residential   mortgages       $   24,718       $   35,641       $   3,841       $   4,997         Consumer   receivables       9,835       9,540       1,593       2,241         Pooled corporate   obligations       66,873       68,340       20,688       26,223         Other asset-backed   obligations       8,997       8,829       4,021       3,573         Total asset-backed   obligations       $   110,423       $   122,350       $   30,143       $   37,034                            (1)          Excludes intercompany insurance of $13,463 million in 2005 and $7,143 million in 2004 relating to FSA-insured GICs issued by the GIC Affiliates. In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed by the Company to be significant, given other more relevant measures of diversification, such as issuer or industry diversification. 100     The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company’s net par amount outstanding (in millions) of insured municipal securities as of December 31, 2005:     State               Number of   Issuers       Net Par Amount   Outstanding       Percent of Total   Municipal Net   Par Amount   Outstanding       Ceded Par   Amount   Outstanding         California           985               $   30,159               13.3   %           $   10,467             New York           671               19,555               8.6               9,718             Texas           730               15,458               6.8               5,301             Pennsylvania           752               14,843               6.5               3,791             Florida           277               12,063               5.3               4,004             Illinois           653               11,255               5.0               5,411             New Jersey           584               10,459               4.6               5,644             Washington           328               8,289               3.6               3,192             Michigan           499               8,252               3.6               2,219             Massachusetts           206               6,309               2.8               3,325             Ohio           332               5,239               2.3               2,194             Wisconsin           437               4,938               2.2               1,297             Georgia           117               4,743               2.1               1,457             All other U.S.   jurisdictions           2,937               63,251               27.9               23,027             International           112               12,247               5.4               9,417             Total           9,620               $   227,060               100.0   %           $   90,464               14.   RELATED PARTY TRANSACTIONS For the years ended December 31, 2005, 2004 and 2003, the Subsidiaries ceded premiums of $31.6 million, $35.2 million and $48.8 million, respectively, to subsidiaries of XL Capital Ltd (“XL”), a major Bermuda-based insurance holding company, which owned an interest in FSA International prior to October 2005, when it redeemed its interest in exchange for $39.1 million. During 2005, 2004 and 2003, the Company paid dividends to XL of $16.3 million, $7.0 million and $3.3 million, respectively. The amounts included in prepaid reinsurance premiums at December 31, 2005 and 2004 for reinsurance ceded to subsidiaries of XL were $84.4 million and $70.3 million, respectively. The amounts of reinsurance recoverable for unpaid losses at December 31, 2005 and 2004 for reinsurance ceded to subsidiaries of XL were $1.8 million and $8.2 million, respectively. The Subsidiaries earned premiums of $2.5 million in the first half of 2003 relating to the guarantees of debt issued or assets purchased by FSA Global and Canadian Global. Intercompany premiums earned relating to VIEs have been eliminated in consolidation for periods subsequent to July 1, 2003. The Subsidiaries earned premiums of $28.0 million, $28.0 million and $20.5 million for the years ended December 31, 2005, 2004 and 2003, respectively, relating to business with affiliates of Dexia. Deferred premium revenue relating to those transactions was $19.5 million and $17.0 million at December 31, 2005 and 2004, respectively. Gross par outstanding relating to those transactions was $21.5 billion and $24.0 billion at December 31, 2005 and 2004, respectively. The Company also paid Dexia a fee of $0.7 million in 2003 relating to business in which both Dexia and the Company were involved. No payments were made in 2004 and 2005. For the year ended December 31, 2005, the Company recorded a pre-tax loss of $12.0 million, and for the years ended December 31, 2004 and 2003, the Company recorded pre-tax income of $97.6 million and $52.9 million, respectively, relating to swaps where Dexia was the counterparty. The Company recorded other assets of $323.5 million and other liabilities of $13.9 million in 2005 and recorded other assets of $353.1 million and other liabilities of $17.2 million in 2004, primarily  101    relating to swaps where Dexia was the counterparty. In addition, at December 31, 2005 and 2004, the Company had $172.0 million and $163.0 million in VIE debt, respectively, relating to debt issued by the Company and purchased by Dexia. During 2005 and 2004, the Company recorded $9.3 million and $8.8 million, respectively, in VIE net interest expense relating to such debt. 15.   DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The Company determines fair value using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair-value amounts. For bonds, equity securities, the FP Investment Portfolio, the FP Investment Portfolio pledged as collateral and the VIE bond portfolio, the carrying amount represents fair value. The fair value is based on quoted market price or redemption value for the Company’s investment in XLFA. For short-term investments, including the FP short-term investment portfolio and the VIE short-term investments, the carrying amount is cost, which approximates fair market value due to the short maturity of the instruments. For cash, receivable for investments sold, and payable for investments purchased, the carrying amount is cost, which approximates fair value because of the short maturity of these instruments. For assets acquired under refinancing transactions, the fair value is either the present value of the expected cash flows or quoted market prices as of the reporting date. For deferred premium revenue, net of prepaid reinsurance premiums, the carrying amount represents the Company’s future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance policy. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the statutory premiums that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of that portion of the premiums retained by the Company to compensate it for originating and servicing the insurance contract. For notes payable, the carrying amount of notes payable represents the principal amount due at maturity. The fair value is based on the quoted market price. For installment premiums, consistent with industry practice, there is no carrying amount since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be received under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract. For GICs and VIE debt, the fair value is the present value of the expected cash flows as of the reporting date. For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is the net present value of the expected cash flows for specifically identified claims and inherent losses in the Company’s insured portfolio, which management believes is a reasonable proxy for fair value. For fair-value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates. 102    The table below shows the carrying amount and fair value of the Company’s financial instruments (in thousands):             As of December 31, 2005       As of December 31, 2004                 Carrying   Amount       Fair Value       Carrying   Amount       Fair Value         Assets:                                         Bonds       $   4,382,037       $   4,382,037       $   4,116,088       $   4,116,088         Equity securities       54,370       54,370       54,300       54,300         Short-term   investments       182,645       182,645       119,746       119,746         FP bond portfolio       11,827,824       11,827,824       7,925,072       7,925,072         FP short-term   investment portfolio       1,015,509       1,015,509       268,125       268,125         FP bond portfolio   pledged as collateral       —       —       5,913       5,913         VIE bonds       1,155,992       1,155,992       1,346,355       1,346,355         VIE short-term   investments       2,674       2,674       1,194       1,194         Cash       20,117       20,117       14,353       14,353         Assets acquired in   refinancing transactions       467,873       460,770       749,208       748,118         Fair-value   adjustments for derivatives       494,490       494,490       642,045       642,045         Receivable for   investments sold       1,382       1,382       161       161         Liabilities:                                         Deferred premium   revenue, net of prepaid reinsurance premiums       1,509,867       1,295,312       1,336,232       1,154,461         Losses and loss   adjustment expenses, net of reinsurance recoverable on unpaid losses       169,379       169,379       144,522       144,522         GIC and VIE debt       14,947,118       15,185,891       10,444,051       10,751,688         Notes payable       430,000       423,904       430,000       437,556         Fair-value   adjustments for derivatives       61,924       61,924       25,582       25,582         Payable for investments   purchased       91,529       91,529       262,033       262,033         Off-balance-sheet   instruments:                                         Installment premiums       —       438,109       —       413,876                           16.   LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES Activity in the liability for losses and loss adjustment expenses, which consists of the case and non-specific reserves, is summarized as follows (in millions):             Case Reserve Activity for the   Year Ended December 31,                   2005            2004              2003             Gross balance at   January 1           $   80.6               $   121.9               $   134.0             Less reinsurance   recoverable           35.4               59.2               76.0             Net balance at   January 1           45.2               62.7               58.0             Transfer from non-specific   reserve           10.3               30.7               12.7             Restructured   transactions           —               (13.9   )           (2.2   )         Paid (net of recoveries) related to:                                                         Current year           —               —               —             Prior year           (2.0   )           (34.3   )           (5.8   )         Total paid           (2.0   )           (34.3   )           (5.8   )         Net balance at   December 31           53.5               45.2               62.7             Plus reinsurance   recoverable           36.3               35.4               59.2             Gross balance at December 31           $89.8               $   80.6               $   121.9                 103                 Non-Specific Reserve Activity   for the Year Ended December 31,                      2005                 2004                2003             Balance at   January 1           $   99.3               $   111.5               $   89.7             Provision for losses                                                         Current year           20.4               20.4               22.4             Prior year           5.0               0.2               12.1             Transfers to case   reserves           (10.3   )           (30.7   )           (12.7   )         Restructured   transactions           1.5               (2.1   )           —             Balance at   December 31           115.9               99.3               111.5             Total case and non-specific reserves           $   205.7               $   179.9               $   233.4               The gross and net par amounts outstanding on transactions with case reserves were $612.7 million and $519.5 million, respectively, at December 31, 2005. The net case reserve consisted primarily of seven CDO transactions and one municipal transaction, which collectively accounted for approximately 94% of the total net case reserve. The remaining 11 exposures were in various sectors. During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on in-force business. Case reserves increased $8.3 million primarily due to deterioration of specific CDO risks. During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior years and $3.2 million related to reassumptions of previously ceded business, offset by reserve releases primarily related to a large refinancing transaction in 2004. The non-specific reserves decreased $12.2 million in 2004, primarily due to transfers from the non-specific reserve to the case reserves of $30.7 million, offset by loss expense of $20.6 million. Case reserves decreased $17.5 million due to (1) a large, voluntarily accelerated transaction that had a $34.3 million payment and (2) reclassifications from reserves to asset valuation accounts for refinanced transactions of $13.9 million, partially offset by transfers from the non-specific reserve of $30.7 million (see Note 22). In September 2004, FSA exercised its rights to have the collateral of a defaulted collateralized bond obligation liquidated at a public sale, in which the Company offered the highest bid. The Company acquired the collateral to gain control of the portfolio in order to mitigate future losses. The previously established case reserve was drawn down to reflect the excess of the purchase amount over the fair value of the collateral. The remaining $9.5 million balance in the case reserve related to this transaction was returned to the non-specific reserve. After reevaluating its requirements for the CDO portion of the non-specific reserve, the Company then reduced the non-specific reserve by $9.5 million, which was partially offset by normal reserve additions. The net amount transferred from the case reserves to the non-specific reserve was $1.4 million, which also included a transfer from the non-specific to the case reserves for a municipal utility transaction. The CDO portfolio continues to perform within the expectations reflected in previously recorded provisions for CDOs. During 2003, the Company charged $34.5 million to loss expense, comprising $9.2 million related to the CDO portfolio discussed below, $22.4 million for origination of new business and $2.9 million for the accretion of the discount on prior years’ reserves. The non-specific reserve increased by $21.8 million in 2003, consisting of the loss expense, a transfer to the non-specific reserve of $1.4 million representing recoveries received on prior-year transactions and a transfer of $14.1 million from the non-specific reserve to case reserves. In addition, the Company reclassified $2.2 million of case reserves as an asset valuation account relating to a restructured transaction involving securitized loans (see Note 22). Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to  104    monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s actual loss experience, its future mix of business and future economic conditions. Impact of Hurricanes The Company evaluated its insured portfolio to assess the potential impact of Hurricanes Katrina, Rita and Wilma, which occurred in 2005. The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. Together, the non-specific reserve and case reserves represent the Company’s estimate of total loss liability. The Company believes that its total loss liability is adequate given the current information. Generally, when an insured credit deteriorates to a point where unreimbursed claims are expected, a case reserve is established. As of March 24, 2006, FSA had not received notice of payment default on any exposures related to Hurricanes Katrina, Rita or Wilma. To date, based on the Company’s review of its exposure, 11 credits, with aggregate net par exposure of $215.8 million, have the most significant risk of loss. FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. In the case of perpetual obligations, FSA may experience claims, but if the population returns in adequate numbers, reimbursement is likely. Eight of the 11 obligations with significant risk of loss are perpetual. The Company monitors its exposure to Hurricanes Katrina and Rita in Louisiana and Mississippi and has determined that no case reserve is required. Of the 11 credits with significant risk of loss, the Company has identified two high-priority risks. These risks are perpetual obligations, on which the Company may have to pay claims of up to $44.0 million in a worst-case scenario. However, in these two cases the Company expects that, so long as the population returns in adequate numbers, it would suffer only the lost interest income on any claims paid until the issuer repaid the Company at some point in the future. In order for a community in Louisiana to restructure and potentially reduce its indebtedness, the Bond Commission, which is headed by the State Treasurer, must authorize such action. The State Treasurer has publicly represented that the Bond Commission will not permit any Louisiana municipality to declare bankruptcy. Municipalities in Mississippi are not authorized to file for bankruptcy and therefore have no mechanism under law to adjust their payment obligations. Unlike the corporate market, the municipal market has no private or equity source of capital and therefore lacks any means of starting fresh with a clean slate with debts and liabilities rejected or adjusted in bankruptcy. To file for bankruptcy, or to leave rated indebtedness unpaid in a bankruptcy proceeding, would serve to tarnish the issuer and the region and effectively deny the subject municipality and similar issuers of debt within the state access to capital. Historically, rather than bankruptcy and adjustment of debt, financially distressed municipalities have been subjected to supervision and control by state-created authorities that act both as issuers of debt, secured by a discrete, newly identified revenue stream, and as fiscal monitors. Both the federal government and the executive and legislative branches of the affected states have considered or are expected to consider proposals or legislation to assist the municipalities and facilitate recovery. An example of such an enactment at the federal level is the Community Disaster Loan Act of 2005, under which the federal government has begun to make loans to affected municipalities. In addition, FSA’s asset-backed transactions, which are generally backed by pools of geographically diverse assets, show no unusual concentrations in the affected areas. The loss estimation process involves the exercise of considerable judgment and therefore the Company’s ultimate hurricane-related losses may be materially different from the current estimate and may affect future operating results. 105    17.   QUARTERLY FINANCIAL INFORMATION (UNAUDITED)           First       Second       Third       Fourth       Full Year                 (in thousands)         2005                                                 Gross premiums written       $   164,049       $   169,677       $   236,751       $   263,304       $   833,781         Net premiums written       109,502       143,916       160,918       163,358       577,694         Net premiums earned       94,881       96,254       116,832       96,092       404,059         Net investment income       49,445       50,404       50,696       50,282       200,827         Losses and loss adjustment expenses       3,984       6,238       10,185       4,958       25,365         Net realized and unrealized gains on derivative   instruments       (70,811   )   18,179       (42,431   )   (77,412   )   (172,475   )     Income before income taxes, minority interest and   equity in earnings (losses) of unconsolidated affiliates        82,231       235,832       97,136       49,872       465,071         Net income       $   63,156       $   129,307       $   73,811       $   59,834       $   326,108         2004                                                 Gross premiums written       $   189,521       $   236,100       $   198,171       $   208,188       $   831,980         Net premiums written       116,494       166,581       148,831       155,863       587,769         Net premiums earned       92,210       101,719       100,585       100,501       395,015         Net investment income       41,077       41,555       43,684       45,735       172,051         Losses and loss adjustment expenses       7,700       7,665       (4,263   )   9,497       20,599         Net realized and unrealized gains (losses) on   derivative instruments       52,155       (65,247   )   148,041       194,310       329,259         Income before income taxes, minority interest,   equity in earnings (losses) of unconsolidated affiliates and cumulative   effect of accounting change       160,279       37,609       224,043       158,583       580,514         Net income       $   101,611       $   57,540       $   114,190       $   105,266       $   378,607                                        18.   EQUITY INVESTMENTS The Company made an additional equity investment in SPS of $10.3 million in 2004, and did not make any equity investments in SPS in 2005 or 2003. In 2005, the Company sold its investment in SPS. At December 31, 2004, the Company had a 34.1% interest in SPS. The Company’s investment in SPS was accounted for using the equity method of accounting. Amounts recorded by the Company in connection with SPS at December 31, 2005, 2004 and 2003 were as follows (in thousands):             2005       2004       2003         Investment in SPS       —       $   49,645       $   46,423         Equity in earnings   (losses) from SPS (pre-tax)       1,160       (7,100   )   (13,548   )                   SPS’s business is subject to regulation, supervision and licensing by various federal, state and local authorities. In October 2002, the Federal Trade Commission (the “FTC”) informed SPS that it was investigating whether SPS’s loan servicing or other practices violated the Fair Debt Collection Practices Act, the Fair Credit Reporting Act, Section 5 of the Federal Trade Commission Act or other laws enforced by the FTC. On November 12, 2003, the FTC announced a settlement with SPS, resolving the FTC’s civil allegations against SPS. Pursuant to that settlement, SPS paid $40.0 million to the FTC to compensate consumers who suffered harm. The settlement enjoins SPS from future law violations and imposes new restrictions on SPS’s business practices. A related settlement of numerous class action lawsuits against SPS has been approved by a federal district court in Massachusetts. The $10.3 million additional equity  106    investment in SPS made by the Company in 2004 funded a portion of the $40.0 million payment that was required to be made to the FTC under the terms of the FTC’s settlement agreement with SPS. In the third quarter of 2004, the Company determined that its $7.6 million of goodwill associated with its investment in SPS was impaired, and it charged that amount to income, as a result of challenges encountered by SPS in acquiring new business, despite servicer ratings of “Average.” In October 2005, the Company sold its investment in SPS to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash at closing and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the Company’s subsidiary that owned the SPS investment made customary representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Based on an estimate of the assets retained and liabilities assumed, the Company recorded a $0.4 million loss on the sale of SPS. The Company will continue to evaluate the appropriate carrying value of the liabilities assumed and whether the assets are impaired. FSA’s 13% investment in preferred shares of XL Financial Assurance Ltd (“XLFA”), a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current-year earnings were distributed. Based on this formula, in 2004, the Company adopted a policy of carrying this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current-year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million. Until the fourth quarter of 2004 this investment was accounted for using the equity method of accounting because the Company has significant influence over XLFA’s operations. In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) reached a consensus that under EITF Issue 02-14, “Whether an Investor Should Apply the Equity of Method of Accounting to Investments Other Than Common Stock” (EITF 02-14), an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The EITF 02-14 consensus is applicable to reporting periods beginning after September 15, 2004. In accordance with this consensus, the Company no longer accrues undistributed earnings related to its investment in XLFA. Amounts recorded by the Company in connection with XLFA as of December 31, 2005, 2004 and 2003 are as follows (in thousands):             2005       2004       2003         Equity securities       $   54,300       $   54,300       —         Investment in   XLFA       —       —       $   64,440         Equity in   earnings from XLFA (pre-tax)       —       3,761       19,077         Dividends earned from   XLFA       8,926       14,103       6,640                        107     19.   MINORITY INTEREST IN SUBSIDIARY In 1998, the Company and XL entered into a joint venture, establishing two Bermuda-domiciled financial guaranty insurance companies—FSA International and XLFA. At December 31, 2004, XL owned a minority interest in FSA International and the Company owned a minority interest in XLFA. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect wholly owned subsidiary of the Company. The preferred shares were Cumulative Participating Voting Preferred Shares that, in total, had a minimum fixed dividend of $1.5 million per annum. In 2005, 2004 and 2003, FSA International paid preferred dividends of $16.3 million, $7.0 million and $3.3 million, respectively, to XL. For the years ended December 31, 2005, 2004 and 2003, the Company recognized minority interest of $6.9 million, $7.0 million and $9.3 million, respectively. 20.   GIC AND VIE DEBT The obligations under GICs issued by the GIC Affiliates may be called at various times prior to maturity based on certain agreed-upon events. As of December 31, 2005, interest rates were between 0.81% and 5.95% per annum on outstanding GICs and between 1.12% and 6.61% per annum on VIE debt. Payments due under GICs are based on expected withdrawal dates and exclude hedge accounting adjustments and prepaid interest of $20.4 million, and include accretion of $868.0 million. VIE debt includes $1,081.8 million of future interest accretion on zero-coupon obligations. The following table presents (in millions) the combined principal amounts due under GICs and VIE debt for 2006 and each of the next four years ending December 31, and thereafter:             Principal   Amount         2006       $   3,573.0         2007       2,112.2         2008       801.9         2009       1,298.6         2010       2,202.8         Thereafter       6,928.8         Total       $   16,917.3           21.   DERIVATIVE INSTRUMENTS Credit Default Swaps FSA has insured a number of CDS with the expectation that these transactions will not be subject to a market value termination for which the Company would be liable. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. The Company recorded $89.2 million, $69.1 million and $57.7 million of net earned premium under these agreements for the years ended 2005, 2004 and 2003, respectively. Changes in the fair value of CDS, which were gains of $11.1 million, $56.4 million and $34.8 million for the years ended December 31, 2005, 2004, and 2003, respectively, were recorded in net realized and unrealized gains on derivative instruments in the statements of operations and comprehensive income. The Company included net par outstanding of $66.6 billion and $66.0 billion relating to these CDS transactions at December 31, 2005 and December 31, 2004, respectively, in the asset-backed balances in Note 13. The gains or losses recognized by recording these contracts at fair value are determined each quarter based on  108    quoted market prices, if available. If quoted market prices are not available, then the determination of fair value is based on internally developed estimates. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and the Company’s ability to obtain reinsurance for its insured obligations. The Company does not believe that the fair-value adjustments are an indication of potential claims under FSA’s guarantees. The average life of these contracts is 3.2 years. The inception-to-date gain on the CDS portfolio was $57.7 million at December 31, 2005 and $46.6 million at December 31, 2004, and was recorded in other assets. Interest Rate and Foreign Exchange Rate Derivatives The Company utilizes interest-rate derivatives to convert from fixed to floating the interest rates on assets and liabilities. All gains and losses from changes in the fair value of derivatives that do not qualify for hedge accounting are recognized immediately in the statements of operations and comprehensive income in net unrealized and realized gains (losses) on derivative instruments. Hedge accounting is applied to derivatives designated as hedging instruments in a fair-value hedge, provided certain criteria are met. The Company enters into derivative contracts to manage interest-rate and foreign currency exposure in its FP Investment Portfolio, GICs, VIE debt and VIE Portfolio. The derivative contracts are recorded at fair value. These derivatives generally include interest-rate futures and interest-rate and currency swap agreements, which are primarily utilized to convert fixed-rate debt and investments into U.S. dollar floating-rate debt and investments. The gains and losses related to the fair value of derivatives are included in net realized and unrealized gains (losses) on derivative instruments. The inception-to-date net unrealized loss on derivatives used to hedge GIC liabilities and the financial products bond portfolio of $56.9 million and $2.2 million at December 31, 2005 and December 31, 2004, respectively, is recorded in other assets or accrued expenses and other liabilities, as applicable. The inception-to-date net unrealized gain on the outstanding derivatives used to economically hedge the VIE debt and VIE bond portfolio of $433.7 million and $570.8 million at December 31, 2005 and December 31, 2004, respectively, are recorded in other assets and accrued expenses and other liabilities, as applicable. Other Derivatives The Company enters into various other derivative contracts that do not qualify for hedge accounting treatment under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). These derivatives include swaptions, caps and other derivatives, which are used principally as protection against large interest-rate movements. Gains and losses on these derivatives are reflected in net realized and unrealized gains (losses) on derivative instruments in the statements of operations and comprehensive income. 22.   REFINANCED TRANSACTIONS The Company generally has rights under its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate future losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA’s rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Affiliates. The refinancing vehicles are consolidated into the Company’s financial statements. The Company maintains its reinsurance on these transactions. 109    The following table presents the components of the assets acquired in refinancing transactions (in thousands):             As of December 31,                 2005       2004         Assets acquired in refinancing   transactions                         Securitized loans       $   296,965       $   369,749         Bonds       9,145       157,036         Asset-backed   senior notes       59,276       90,516         Equity securities       3,488       15,659         Mortgage loans       56,165       77,462         Short-term   investments       37,512       27,749         Other assets       5,322       11,037         Total       $   467,873       $   749,208           Securitized loans are carried at cost, net of losses at the date of purchase. Income is recorded based on the effective yield method. The accretable yield on the securitized loans at December 31, 2005, 2004 and 2003 was $142.3 million, $145.7 million and $147.2 million, respectively. The cash flows on the securitized loans, net of reinsurance, are monitored and the effective yield modified to reflect any change in the cash flow estimate on a prospective basis. Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all the risk of further asset decline (except as provided by reinsurance) and maintains control over key decisions regarding the trusts (such as removal of the servicer, sale of the assets and liquidation of the entity), the trusts were consolidated with the Company for accounting purposes. The Company also consolidated the refinancing vehicles. Bonds, equity securities and mortgage loans represent liquidations of previously insured obligations and subsequent purchases of the underlying collateral. Bonds and equity securities are available for sale and carried at fair value. At December 31, 2005, there were no securities in the refinanced asset portfolio in an unrealized loss position for a continuous 12-month period or longer. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired. The credit quality of bonds within the refinanced asset portfolio at December 31, 2005 was as follows:     Rating(1)               Percent of Bonds         BBB           19.0   %         CCC           67.6             D            5.4             NR           8.0                         100.0%              (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio were as follows (in thousands):             As of December 31, 2005                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Corporate securities       $   5,946           $   3,199               —           $   9,145         Asset-backed   securities       59,920           —               (644   )       59,276         Short-term   investments       37,512           —               —           37,512         Total       $   103,378           $   3,199               $   (644   )       $   105,933                               110                   As of December 31, 2004                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Corporate securities       $   151,895           $   5,743               $   (602   )       $   157,036         Asset-backed   securities       89,500           1,016               —           90,516         Short-term   investments       27,749           —               —           27,749         Total       $   269,144           $   6,759               $   (602   )       $   275,301           The amortized cost and fair value of equities held within the refinanced asset portfolio were as follows (in thousands):             As of December 31, 2005                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Equity securities           $   2,206               $   1,282               —               $   3,488                                                  As of December 31, 2004                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Equity securities           $   13,919               $   1,903               (163   )           $   15,659                                      The amortized cost and fair value of fixed-income assets within the refinanced asset portfolio at December 31, 2005, are shown below by contractual maturity (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized Cost       Fair Value         Due in one year   or less           $   37,967           $   37,982         Due after one   year through five years           17,906           17,906         Due after five   years through ten years           47,505           50,045         Total           $   103,378           $   105,933           At December 31, 2005, there were no securities in an unrealized loss position for a continuous 12-month period or longer. The Company determined that there were six securities considered other-than-temporarily impaired. For 2005, a $4.5 million impairment was recorded in the consolidated statements of operations and comprehensive income. 23.   SEGMENT REPORTING The Company operates in two business segments: financial guaranty and financial products. The financial guaranty segment is primarily in the business of providing financial guaranty insurance on municipal and asset-backed obligations. It also includes the results of the VIEs that were consolidated for the first time in the third quarter of 2003. The FP Segment includes the GIC operations of the Company, which issues GICs to municipalities and other market participants. GICs provide for the return of principal and the payment of interest at pre-specified rates. The following tables summarize the financial  111    information (in thousands) by segment as of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003:             For the Year Ended December 31, 2005                 Financial   Guaranty       Financial   Products       Intersegment   Eliminations       Total         Revenues:                                         External       $   615,739       $   365,496       —       $   981,235         Intersegment       38,693       41,335       (80,028   )   —         Expenses:                                         External       141,837       374,327       —       516,164         Intersegment       41,335       38,693       (80,028   )   —         Pre-tax segment earnings       $   448,422       $   18,525       —       466,947         Current and deferred taxes                               (128,900   )     SFAS133 CDS and economic interest-rate hedge   fair-value adjustments                               (11,939   )     Net income                               $   326,108         Segment assets       $   9,841,539       $   14,169,383       $   (2,009,280   )   $   22,001,642                                       For the Year Ended December 31, 2004                 Financial   Guaranty       Financial   Products       Intersegment   Eliminations       Total         Revenues:                                         External       $   980,321       $   167,948       —       $   1,148,269         Intersegment       21,892       30,620       (52,512   )   —         Expenses:                                         External       391,138       176,617       —       567,755         Intersegment       30,620       21,892       (52,512   )   —         Pre-tax segment earnings       $   400,881       $   6,455       —       $   407,336         Current and deferred   taxes                               (111,160   )     SFAS133 CDS and economic interest-rate hedge   fair-value adjustments                               82,431         Net income                               $   378,607         Segment assets       $   9,820,672       $   9,379,900       $   (2,119,564   )   $   17,081,008                                       For the Year Ended December 31, 2003                 Financial   Guaranty       Financial   Products       Intersegment   Eliminations       Total         Revenues:                                                         External       $   827,360           $   70,318               —           $   897,678         Intersegment       7,436           25,875               (33,311   )       —         Expenses:                                                         External       378,906           95,359               —           474,265         Intersegment       25,875           7,436               (33,311   )       —         Pre-tax segment earnings       $   345,956           $   (8,649   )           —           $   337,307         Current and deferred   taxes                                               (95,784   )     Cumulative effect of   accounting change                                               4,800         SFAS133 CDS and economic   interest-rate hedge fair-value adjustments                                               51,804         Net income                                               $   298,127           112    The intersegment assets consist of (1) intercompany notes issued by FSA and held within the FP Investment Portfolio and (2) GICs issued by the GIC Affiliates and held within the VIE Portfolio. The intersegment revenues and expenses relate to interest income and interest expense on intercompany notes and GICs. The SFAS 133 fair-value adjustments for CDS are a reconciling item between pre-tax segment operating earnings and net income. In addition, management subtracts the impact of interest-rate derivatives when analyzing the segments, as it believes that, by removing the effect of the one-sided accounting caused by marking the derivatives, but not the hedged assets or liabilities, to fair value, the measure will more closely reflect the underlying performance of segment operations. 24.   OTHER ASSETS AND LIABILITIES The detailed balances that comprise other assets and accrued expenses and other liabilities at December 31, 2005 and 2004 are as follows (in thousands):             2005       2004         Other assets:                         Fair value of VIE swaps       $   433,670       $   570,764         VIE other invested assets       146,710       156,540         Securities purchased under agreements to resell       350,000       —         Deferred compensation trust       107,140       112,941         Tax and loss bonds       105,324       102,193         Accrued interest on VIE swaps       108,421       99,794         Accrued interest income       76,295       63,614         Fair-value adjustments on derivatives       60,820       71,281         Other assets       267,561       151,257         Total other assets       $   1,655,941       $   1,328,384                       2005       2004         Accrued expenses   and other liabilities:                         Payable for securities purchased       $   91,529       $   262,033         Deferred compensation trust       107,140       112,941         Equity participation plan       116,887       123,382         Securities sold under agreements to repurchase       —       5,656         Fair-value adjustments on derivatives       61,924       25,582         Other liabilities       431,694       313,931         Total accrued expenses   and other liabilities       $   809,174       $   843,525           25.   VARIABLE INTEREST ENTITIES In January 2003, the FASB issued FIN 46, which addresses consolidation of VIEs that have one or both of the following characteristics: (a) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity; and (b) the equity investors lack the direct or indirect ability to make decisions about the entity’s activities through voting rights or similar rights, the obligation to absorb the expected losses of the entity if they occur or the right to receive the expected residual returns of the entity if they occur. In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), “Consolidation of Variable Interest Entities, an interpretation of ARB 51” (“FIN 46R”). FIN 46R replaced FIN 46 and is effective for public companies for periods after December 15, 2003. The Company has identified three SPEs that satisfy the consolidation requirements. 113    FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Affiliates. Similarly, Premier holds GICs issued by the GIC Affiliates in their investment portfolios. In each such case, the Company’s GIC liability and asset are eliminated in consolidation. At December 31, 2005, $1,142.1 million was eliminated as a result of such consolidation. All intercompany insured amounts between FSA and FSA Global and Canadian Global previously included in the Company’s outstanding exposure are excluded from the Notes to the Consolidated Financial Statements for December 31, 2005 and 2004. FIN 46R requires that, upon consolidation, the Company initially measure the VIE’s assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). The increase in total assets and total liabilities related to the consolidation of these entities was $1.9 billion at July 1, 2003, when they were first consolidated. The difference upon consolidation was reflected as a cumulative effect of a change in accounting principle at July 1, 2003. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax. There were no cumulative income statement effects from consolidating FSA Global and Premier. The following table presents the impact of consolidation of the VIEs.             2005       2004         VIE net interest income       $   67,152       $   52,665         FSA’s net premiums   earned on VIE bonds and debt       (3,613   )   (5,351   )     Net realized and   unrealized gains (losses) on derivatives       (133,915   )   249,752         Total revenues       $   (70,376   )   $   297,066         VIE net interest expense       $   85,809       $   105,173         Other operating expenses       50       (1,054   )     Foreign exchange loss       (162,398   )   79,270         Total expenses       $   (76,539   )   $   183,389           VIE Investments All bonds in the VIE Portfolio are insured by FSA. The credit quality of the VIE Portfolio, without the benefit of FSA’s insurance, at December 31, 2005 was as follows:     Rating(1)               Percent of Bonds         AAA           2.3   %         A            95.5             BB           2.2                         100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. The amortized cost and fair value of bonds in the VIE Portfolio were as follows (in thousands):     December 31, 2005               Amortized Cost       Fair Value         Obligations of states   and political subdivisions           $   15,879           $   15,879         Corporate securities           20,013           19,327         Foreign securities           8,995           9,841         Asset-backed   securities(1)           1,110,945           1,110,945         Short-term   investments           2,674           2,674         Total           $   1,158,506           $   1,158,666           114          December 31, 2004               Amortized Cost       Fair Value         Obligations of states   and political subdivisions           $   16,007           $   16,007         Corporate securities           156,030           157,990         Foreign securities           56,077           57,983         Asset-backed   securities(1)           1,114,375           1,114,375         Short-term   investments           1,194           1,194         Total           $   1,343,683           $   1,347,549          (1)          Asset-backed securities consist of floating-rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation. Management believes that amortized cost closely approximates fair value for these securities. The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were no securities in an unrealized loss position. The Company determined that no investments were considered other-than-temporarily impaired. The amortized cost and fair value of bonds in the VIE Portfolio at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized Cost       Fair Value         Due in one year   or less           $   2,674           $   2,674         Due after one   year through five years           29,008           29,168         Due after five   years through ten years           —           —         Due after ten   years           15,879           15,879         Asset-backed   securities (stated maturities of 4 to 17 years)           1,110,945           1,110,945         Total           $   1,158,506           $   1,158,666           26.   RECENTLY ISSUED ACCOUNTING STANDARDS In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155, “Accounting for Certain Hybrid Financial Instruments (“SFAS 155”). SFAS 155 provides guidance with respect to bifurcation of embedded credit risk in a special purpose entity. The adoption of SFAS 155 is not expected to have a material impact on the Company’s financial position or results of operations. In November 2005, the FASB issued FASB Staff Position (“FSP”) 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which supersedes certain requirements of EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and amends SFAS 115 and Accounting Principles Board Opinion (“APB”) 18, “The Equity Method of Accounting for Investments in Common Stocks.” FSP 115-1 outlines a three-step model to identify investment impairments in each reporting period. First, for each reporting period, individual securities are determined to be impaired if the fair value of a security is less than its cost. Second, impaired securities are evaluated as to whether the impairment is other than temporary based on existing applicable guidance. Lastly, if the impairment is other than temporary, an impairment loss is recognized in earnings equal to the difference between the investment’s cost and fair value as of the reporting date. Under FSP 115-1, the disclosure requirements required by EITF 03-1 issued in December 2003 remain in effect. EITF 03-1 requires the Company to disclose certain information about unrealized losses on its investment  115    portfolio that have not been recognized as other-than-temporary impairments. The requirements under FSP 115-1 are effective for reporting periods beginning after December 15, 2005. The Company believes that the adoption of FSP 115-1 will not have a material effect on the Company’s financial position or results of operations. See Note 3 for disclosures required by EITF 03-1. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123-R, “Share-Based Payment” (“SFAS 123-R”). This Statement is a revision of SFAS 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date using the fair-value measurement method. SFAS 123-R is effective for annual periods beginning after June 15, 2005. The adoption of SFAS 123-R is not expected to have a material impact on the Company’s financial position or results of operations. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. There have been no changes in, or any disagreements with, accountants on accounting and financial disclosure within the two years ended December 31, 2005. Item 9A.                Controls and Procedures. Evaluation of Disclosure Controls and Procedures The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of December 31, 2005. Based on that evaluation and because of the material weakness in internal control over financial reporting discussed below, the Chief Executive Officer and the Chief Financial Officer concluded that as of such date the Company’s disclosure controls and procedures were not effective in providing reasonable assurance that information required to be disclosed in the reports the Company files or submits under the Exchange Act is recorded, processed, summarized and reported as and when required and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, in a manner that allows timely decisions regarding required disclosure. Notwithstanding the material weakness discussed below, the Company’s management has concluded that the financial statements included in this Form 10-K fairly present in all material respects the Company’s financial position, results of operations and cash flows for the periods presented in conformity with generally accepted accounting principles. Changes in Internal Control over Financial Reporting Except as noted below, there were no changes in the internal control over financial reporting that occurred during the year ended December 31, 2005 that materially affected, or that are reasonably likely to materially affect, internal control over financial reporting. 116     Identification of Material Weakness in Internal Control over Financial Reporting A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. Management has concluded that the Company did not maintain effective controls to ensure that hedge accounting was correctly applied pursuant to generally accepted accounting principles. Specifically, the Company’s accounting documentation for certain hedging relationships did not meet the requirements of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and related interpretations and the Company incorrectly applied the short-cut method of hedge accounting to certain other hedge relationships. This control deficiency resulted in the restatement of the Company’s Consolidated Financial Statements for the years ended December 31, 2004, 2003 and 2002, the periods ended March 30, June 30, September 30 and December 31, 2003 and 2004 and opening retained earnings at January 1, 2002. In addition, this control deficiency could result in a misstatement of interest income and expense from financial products and variable interest entities, net realized and unrealized gains and losses on derivative instruments, income from assets acquired in refinancing transactions and related accounts and disclosures that would cause a material misstatement in the annual and interim financial statements. Accordingly, management determined that this control deficiency constituted a material weakness in internal control over financial reporting as of December 31, 2005. Remediation In the Company’s amended annual report on Form 10-K/A for the year ended December 31, 2004, filed December 19, 2005, management stated that it intended to remediate the material weakness in internal control over financial reporting and that it would report on its progress in the present annual report. In particular, management stated that it intended to: ·       revise the Company’s accounting documentation of policies and procedures and review to meet the standard of hedge documentation expected under SFAS 133; and ·       strengthen the Company’s internal knowledge base regarding hedge accounting with improved training and expertise. In accordance with its stated intentions, management has revised the Company’s accounting documentation of policies and procedures and review to meet the standard of hedge accounting under SFAS 133 and is applying such standard to certain liabilities effective January 1, 2006. Management has also worked to strengthen the Company’s internal knowledge base regarding hedge accounting, through improved training designed to ensure that all relevant personnel understand and apply hedge accounting in compliance with SFAS 133. Although it has implemented the remediation procedures as described above, management cannot yet assert that the remediation is effective as it has not had sufficient time to test the operating effectiveness of the newly implemented controls. Management expects that the remediation of this material weakness in internal control over financial reporting will be complete before management and the Company’s independent registered public accounting firm must first report on the effectiveness of the internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. The Company will continue to improve the design and effectiveness of its disclosure controls and procedures and internal control over financial reporting to the extent necessary in the future to provide management with timely access to such material information and to correct any deficiencies that may be discovered in the future. Item 9B.               Other Information. None. 117     PART III Item 10.                 Directors and Executive Officers of the Registrant. Directors On May 19, 2005, the Company’s shareholders appointed twelve directors to serve until the later of the Company’s next annual meeting of shareholders or until their successors have been duly elected and qualified. Information about the directors as of December 31, 2005 is set forth below and in “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.”       Dirk Bruneel   Age 55       Director of the Company since November 2001. Mr. Bruneel   has been a member of the Management Board of Dexia S.A. since July 2001,   and Chairman of the Management Board of Dexia Bank Nederland N.V. since November 2002.   He is currently the Chairman of the Board of Directors of Dexia Securities   France S.A., a member of the Supervisory Board of Dexia Municipal Agency S.A.   and Chairman of the Board of Directors of Artesia Mortgage Capital   Corporation. Mr. Bruneel served as Chairman of the Management Committee   of Artesia Banking Corporation (a Belgian-based bank acquired by Dexia   S.A. in July 2001) from November 1998 until August 2001 and of   BACOB Bank s.c. from January 1995 until August 2001, and was a   member of the Management Committee of Dexia Bank from July 2001 through January 2002.   He currently serves as a member of the Board of Directors of Dexia Insurance,   Dexia Capital Ireland, Dexia Financial Services Ireland, Dexia Investments   Ireland, Banque Artesia Nederland, Ehsal and VEV, and Treasurer of Vlaams Omroeporkest en Kamerkoor.     Robert P. Cochran   Age 56       Chairman of the Board of   Directors of the Company since November 1997, and Chief Executive   Officer and a Director of the Company since August 1990. Mr. Cochran   served as President of the Company and FSA from August 1990 until November 1997.   He has been Chief Executive Officer of FSA since August 1990, Chairman   of FSA since July 1994, and a director of FSA since July 1988.   Prior to joining the Company in 1985, Mr. Cochran was Managing Partner   of the Washington, D.C. office of the Kutak Rock law firm. Mr. Cochran   is a Director of White Mountains Insurance Group, Ltd. and XL Financial   Assurance Ltd.     Bruno Deletre   Age 44       Director of the Company since September 2001. In   January 2006, Mr. Deletre became an Executive Vice President and   member of the Executive Committee of Dexia. Mr. Deletre was a member of   the Executive Board of Dexia Crédit Local from 2001 through January 2006   and Managing Director from December 2003. Prior to that time, he held   various positions in the French Ministry of Finance—Treasury, and served as   Advisor to the French Minister of Economy and Finance from 1995 to 1997.     118         Robert N. Downey   Age 70       Director of the Company since August 1994. Mr. Downey   has been a Senior Director of Goldman Sachs & Co. since 1999, a   Limited Partner from 1991 to 1999, and a General Partner from 1976 until   1991. At Goldman, Sachs & Co., Mr. Downey served as head of the   Municipal Bond Department and Vice Chairman of the Fixed Income Division. Mr. Downey   was a Director of the Securities Industry Association from 1987 through 1991   and served as its Chairman in 1990 and Vice Chairman in 1988 and 1989. He was   also formerly Chairman of the Municipal Securities Division of the Public   Securities Association (known today as the Bond Market Association) and Vice   Chairman of the Municipal Securities Rulemaking Board.      Jacques Guerber   Age 56       Director of the   Company since September 2002. In January 2006, Mr. Guerber   became Vice Chairman of the Management Board of Dexia and a Member of the   Management Board of Dexia Crédit Local. Mr. Guerber was Chairman   of the Executive Board of Dexia Crédit Local from 2000 through January 2006,   and a member of the Executive Committee of Dexia from December 1999 to January 2006.   Prior to then he was Senior Executive Vice President of Crédit Local de   France (subsequently known as Dexia Crédit Local) from 1996 and a member of   that company’s Management Board from 1988. Earlier, he held management   positions in the Local Development Division of Caisse des   Dépôts et Consignations.      David O. Maxwell   Age 75       Director of the   Company since August 1994. Mr. Maxwell was Chairman and Chief   Executive Officer of Fannie Mae from 1981 until his retirement in 1991. Mr. Maxwell   is a member of the advisory boards of Centre Partners II, L.P., Centre   Partners III, L.P. and Centre Partners IV, L.P.     Séan W. McCarthy   Age 46       Director of the Company   since February 1999. Mr. McCarthy has been President and Chief Operating   Officer of the Company since January 2002, and prior to that time served   as Executive Vice President of the Company since November 1997. He has   been President of FSA since November 2000, and served as Chief Operating   Officer of FSA from November 1997 until November 2000. Mr. McCarthy   was named a Managing Director of FSA in March 1989, head of its   Financial Guaranty Department in April 1993 and Executive Vice President   of FSA in October 1999. He has been a director of FSA since September 1993.   Prior to joining FSA in 1988, Mr. McCarthy was a Vice President of   PaineWebber Incorporated.    119         James H. Ozanne   Age 62       Director of the Company since September 2004. Mr. Ozanne   previously served on the Board of Directors of the Company from January 1990   through May 2003, when he became Chief Executive Officer of SPS Holding   Corp., a mortgage servicing holding company in which the Company owned a   minority interest, a position he held until September 2004. He served as   Vice Chairman of the Board of Directors of the Company from May 1998   until July 2000. Mr. Ozanne is Chairman of Greenrange Partners. He   was Chairman of Source One Mortgage Services Corporation, which was a   subsidiary of White Mountains (“Source One”), from March 1997 to May 1999,   Vice Chairman of Source One from August 1996 until March 1997, and   a director of Source One from August 1996 to May 1999. He was   Chairman and Director of Nations Financial Holdings Corporation from January 1994   to January 1996. He was President and Chief Executive Officer of U S   WEST Capital Corporation (“USWCC”) from September 1989 until December 1993.   Prior to joining USWCC, Mr. Ozanne was Executive Vice President of   General Electric Capital Corporation. Mr. Ozanne is currently a director   of Distributed Energy Services Corp. He has been Chairman of PECO Pallet, a   privately owned grocery pallet rental company, since 2000.     Pierre Richard   Age 65       Director and Vice   Chairman of the Company since July 2000. Mr. Richard has been   appointed Chairman of the Board of Directors of Dexia effective January 1,   2006. He was Group Chief Executive and Chairman of the Management Board of   Dexia from December 1999 to December 2005. He had been co-Chairman   of Dexia Group since its creation through the alliance between Crédit Local   de France and Crédit Communal de Belgique in December 1996. In October 1987,   when Crédit Local de France was incorporated, he became its Chief Executive   Officer and then, in December 1993, after the firm’s privatization, he   was named Chairman and Chief Executive Officer. He previously served as   Deputy General Manager of Caisse des Dépôts et   Consignations and, before that, as head of the Local Authorities   Department at the French Ministry of Interior, where he was closely involved   in drafting the new legislation for decentralization. He serves on the boards   of the European Investment Bank, Air France/KLM, Le Monde SA, Credit du Nord   and Generali France Holding. He has been decorated as an Officier   of the Légion d’Honneur and   the Ordre National du Mérite and as a Commandeur of the Ordre of Leopold II.    120         Roger K. Taylor   Age 54       Director of the Company   since February 1995. Mr. Taylor was a part-time employee of the   Company and Vice Chairman of FSA from January 2002 until his retirement   in July 2004. Mr. Taylor served as Chief Operating Officer of the   Company from May 1993 through December 2001 and President of the   Company from November 1997 through December 2001. Mr. Taylor   joined FSA in January 1990, and served FSA as its President from November 1997   until November 2000, a director since January 1992 and a Managing   Director since January 1991. Prior to joining FSA, Mr. Taylor was   Executive Vice President of Financial Guaranty Insurance Company.      Rembert von Lowis   Age 52       Director of the   Company since July 2000. Mr. von Lowis is a member of the   Management Board of Dexia. He became Senior Executive Vice President of   Crédit Local de France in 1993. Mr. von Lowis joined Crédit Local de   France as Chief Financial Officer and member of its Executive Board in 1988.   Earlier, he held management positions in the Local Development Division in Caisse des Dépôts et Consignations and the Local   Authorities Department of the French Ministry of Interior. Mr. Von Lowis   is a director of Dexia CLF Finance Company.     George U. Wyper   Age 50       Director of the   Company since September 2004. Mr. Wyper is the founder and managing   member of Wyper Capital Management, L.P., which he founded in 1998. He was   Senior Managing Director and a member of the Operating Committee of Warburg   Pincus Counsellors, Inc from 1994 to 1998. He served as Chief Investment   Officer of White River Corporation from 1991 to 1994 and as President and   Chief Executive Officer of Hanover Advisors from 1992 to 1994. Prior to 1991,   he was Chief Investment Officer of Fund American Enterprises from 1988 to   1990 and Director of Fixed Income Investments for Fireman’s Fund Insurance   Company from 1987 to 1988. Mr. Wyper is currently President of the   Darien Library and serves on the boards of the Yale School of Management, the   American Numismatic Society and the Museum of Rhode Island School of Design.       On February 16, 2006, the Board of Directors increased the number of directors to 13 and elected Axel Miller to the Board of Directors. Information about Mr. Miller is set forth below and in “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.” 121         Axel Miller   Age 41       Director of the Company   since February 2006. Mr. Miller obtained his law degree, a Licence en droit, from the Université   Libre de Bruxelles. After having worked for 14 years as a lawyer   specialized in finance law, mergers & acquisitions and international   commercial law, Mr. Miller joined the Dexia Group in 2001 as General   Counsel. He became a member of the Management Board of Dexia Bank in January 2002   and Chairman of the Management Board of Dexia Bank and Head of Personal   Financial Services at Group level in January 2003. On January 1,   2006, Mr. Miller became CEO and Chairman of the Management Board of   Dexia. On the same date, he also became a member of the Management Boards of   Dexia Crédit Local (France) and Dexia BIL (Luxembourg). He remains a member   of the Management Board of Dexia Bank (Belgium). He is also a Director of   several Dexia Group companies, Ethias, Crédit du Nord and LVI Holding (Groupe   Carmeuse).        Executive Officers of the Company In addition to Messrs. Cochran and McCarthy (who are described above under the caption “Directors”), the Company’s other executive officers are described below. The Company’s executive officers consist of the members of the Executive Management Committee.    Name               Age       Position     Russell B. Brewer   II       49       Managing   Director of the Company and FSA; Chief Risk Management Officer and Director   of FSA     Joseph W. Simon       47       Managing   Director and Chief Financial Officer of the Company and FSA; Director of FSA     Bruce E. Stern       52       Managing Director,   General Counsel and Secretary of the Company and FSA; Director of FSA      The present principal occupation and five-year employment history of each of the above-named executive officers of the Company, as well as other directorships of corporations currently held by each such person, are set forth below. Mr. Brewer has been a Managing Director of FSA since March 1989 and the Chief Risk Management Officer of FSA since September 2003. Mr. Brewer was the Chief Underwriting Officer of FSA from September 1990 until September 2003. He has been a Managing Director of the Company since May 1999 and a director of FSA since September 1993. From March 1989 to August 1990, Mr. Brewer was Managing Director, Asset Finance Group, of FSA. Prior to joining FSA in 1986, Mr. Brewer was an Associate Director of Moody’s Investors Service, Inc. Mr. Simon was elected a Managing Director and the Chief Financial Officer of the Company and FSA in September 2002, having served in such capacity since April 2002. Prior to joining the Company, Mr. Simon was Chief Financial Officer of Intralinks, a technology company serving the financial markets. Earlier, he worked for TENTV.com, a provider of business to business video portals. From 1993 to 1999, he was a senior financial officer, last serving as the Chief Financial Officer, of Cantor Fitzgerald. Mr. Simon, a certified public accountant, began his professional career at Price Waterhouse in 1983. 122    Mr. Stern has been a Managing Director, the Secretary and the General Counsel of the Company since April 1993. Since April 1993, he has been the Secretary of FSA, and since March 1989, he has been a Managing Director of FSA. He has been a director of FSA since August 1990. Prior to joining FSA as General Counsel in 1987, Mr. Stern was an attorney with Cravath, Swaine & Moore. Audit Committee The Company has a separately designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act. During 2005, the Audit Committee consisted of Messrs. Ozanne (Chairman), Maxwell and Wyper.  In February 2006, Mr. Taylor was elected to the Audit Committee and Mr. Maxwell ceased to be a member of the Committee. All members of the Audit Committee are independent within the meaning of Rule 10A-3 of the Exchange Act. Because the Company has only debt securities listed on the New York Stock Exchange, the additional independence standards for audit committee members imposed by the NYSE are not applicable to the Company. Audit Committee Financial Expert The Board of Directors of the Company has determined that Audit Committee members David O. Maxwell and James H. Ozanne are audit committee financial experts as defined by Item 401(h) of Regulation S-K of the Exchange Act. Code of Ethics The Company has adopted a code of ethics for directors, officers (including the Company’s principal executive officer, principal financial officer, and principal accounting officer and controller) and employees, known as the Code of Conduct. The Company has posted its Code of Conduct on its Internet website, www.fsa.com. The Company intends to satisfy the disclosure requirement under Item 5.05 of Form 8-K regarding amendments to, or waivers from, provisions of its code of ethics that applies to its principal executive officer, principal financial officer and principal accounting officer and controller, or persons performing similar functions, and that relates to any element of the code of ethics definition enumerated in paragraph (b) of Item 406 of Regulation S-K of the Exchange Act, by posting such information on its website, www.fsa.com. Section 16(a) Beneficial Ownership Reporting Compliance Section 16 of the Exchange Act requires periodic reporting by beneficial owners of more than 10% of any equity security registered under Section 12 of the Exchange Act and directors and executive officers of issuers of such equity securities. Upon its merger with a subsidiary of Dexia in July 2000, the Company’s common stock ceased to be registered under Section 12 of the Exchange Act or listed on the NYSE. Consequently, the Company no longer has equity securities registered under Section 12 of the Exchange Act, and the reporting obligations of Section 16 of the Exchange Act do not apply. 123     Item 11.                 Executive Compensation. Summary Compensation Table The table below sets forth a summary of all compensation paid to the chief executive officer of the Company and the other four most highly compensated executive officers of the Company and its subsidiaries, in each case for services rendered in all capacities to the Company and its subsidiaries for the years ended December 31, 2005, 2004 and 2003.                      Annual   Compensation       Long-Term   Compensation(1)                 Name and Principal Position               Year       Salary       Bonus(2)       Dexia   Restricted   Stock   Awards(3)       LTIP   Payouts(2)       All Other   Compensation(4)         Robert P. Cochran       2005       $   500,000       $   3,300,000           $   480,029           $   6,683,093           $   90,000             Chairman of the Board and       2004       500,000       3,400,000           445,727           6,255,877           90,000             Chief Executive Officer       2003       500,000       3,200,000           N/A           9,213,941           90,000             Séan W. McCarthy       2005       320,000       3,000,000           352,959           4,658,710           90,000             President and       2004       310,000       3,000,000           327,741           4,705,296           90,000             Chief Operating Officer       2003       310,000       2,800,000           N/A           6,858,901           90,000             Bruce E. Stern       2005       250,000       900,000           127,070           1,867,355           90,000             Managing Director,   General       2004       240,000       900,000           117,986           2,003,907           90,000             Counsel and Secretary       2003       240,000       800,000           N/A           2,269,286           80,100             Russell B. Brewer II       2005       250,000       900,000           127,070           1,864,458           90,000             Managing Director and       2004       240,000       900,000           117,986           1,956,545           90,000             Chief Underwriting   Officer       2003       240,000       800,000           N/A           2,259,243           75,600             Joseph W. Simon       2005       250,000       800,000           127,070           916,036           90,000             Managing Director and       2004       240,000       750,000           104,889           297,899           66,600             Chief Financial Officer       2003       240,000       500,000           N/A           N/A           33,300                                         (1)          No awards of restricted stock of the Company or options/SARs were made to any of the executives named in the table during the period covered by the table. (2)          Annual compensation for each year includes bonus and LTIP payouts received or deferred by the named executive officer in January or February of the subsequent year. LTIP payouts were made to or deferred by each named executive for each year shown in the table above with respect to performance shares for the three-year performance cycle ending December 31 of such year. For additional information regarding performance shares see “—Equity Plans—Performance Shares.” 124    (3)          Dexia Restricted Stock Awards represents the value of Dexia restricted stock awarded for the years ended December 31, 2005 and 2004 (which awards were made in February 2006 and 2005, respectively), based on the closing market price for ordinary shares of Dexia on the date of grant. The Dexia restricted stock was awarded pursuant to the Company’s 2004 Equity Participation Plan, as amended (the “2004 Equity Plan”), and represents ordinary shares of Dexia subject to certain vesting requirements and restrictions on transfer.   Holders of Dexia restricted stock are entitled to receive all dividends paid on such stock from the date of grant. Generally, one third of an award of Dexia restricted stock vests after 2.5 years and two thirds vests after 3.5 years, with transfer restrictions lapsing six months after the vesting date. The awards reported in the Summary Compensation Table for Messrs. McCarthy, Stern, Brewer and Simon will accordingly vest as follows:             Dexia Restricted Shares Vesting         Name               Second Quarter 2007       Second Quarter 2008       Second Quarter 2009         Séan W. McCarthy           4,821               14,445               9,603             Bruce E. Stern           1,736               5,200               3,457             Russell B. Brewer   II           1,736               5,200               3,457             Joseph W. Simon           1,543               4,815               3,457                                 The 2004 Equity Plan provides that, when a participant becomes eligible for retirement at age 55, shares of Dexia restricted stock vest thereafter to the extent the shares would have vested had the employee actually retired as of any particular date. Because Mr. Cochran became eligible for retirement during 2005, 6,368 of his shares vested during 2005 and the remainder of his awarded shares will vest as follows, except as otherwise provided in his employment agreement: 3,178 shares per fiscal quarter during 2006 and through the first half of 2007, 2,523 per fiscal quarter from the second half of 2007 through the first half of 2008, and 933 shares per fiscal quarter during the second half of 2008 and the first half of 2009. As of December 31, 2005, based on the closing market price of ordinary shares of Dexia on that date, the aggregate holdings and market values of Dexia restricted stock by each named executive officer are set forth below. These amounts exclude Dexia restricted stock awarded in February 2006 and included in the summary compensation table:     Name               Number of   Unvested   Dexia Shares       Market Value         Robert P. Cochran           13,301               $   307,020             Séan W. McCarthy           14,464               333,856             Bruce E. Stern           5,207               120,187             Russell B. Brewer   II           5,207               120,187             Joseph W. Simon           4,629               106,846               Prior to adopting the 2004 Equity Plan, the Company did not have an equity plan that contemplated awards of Dexia restricted stock. The Dexia restricted stock awards for the year ended December 31, 2004 (which awards were made in February 2005), were the first awards made under the 2004 Equity Plan. In its annual report on Form 10-K for the year 2004, the Company disclosed the awards to the named executive officers in its discussion of the 2004 Equity Plan under the caption “Dexia Restricted Stock,” but did not disclose the Dexia restricted stock awards in the Summary Compensation Table. The Company has corrected its disclosure in the Summary Compensation Table above. 125    (4)          All Other Compensation includes contributions by the Company to its Supplemental Executive Retirement Plan (“SERP”) and to its defined contribution pension plan (the “Pension Plan”), as follows:             2005       2004       2003         Officer               Pension Plan       SERP       Pension Plan       SERP       Pension Plan       SERP         Robert P. Cochran           $   18,900           $   71,100           $   18,450           $   71,550           $   18,000           $   72,000         Séan W. McCarthy           18,900           71,100           18,450           71,550           18,000           72,000         Bruce E. Stern           18,900           71,100           18,450           71,550           18,000           62,100         Russell B. Brewer   II           18,900           71,100           18,450           71,550           18,000           57,600         Joseph W. Simon           18,900           71,100           18,450           48,150           9,000           24,300                                         Pension Plan and SERP amounts shown for each year were accrued during that year and paid in January or February of the following year. The Pension Plan provides for a Company funded contribution equal to 9% of cash compensation (salary and bonus) up to the compensation limit specified by the Internal Revenue Service. The SERP provides for an unfunded Company contribution equal to 9% of cash compensation over and above the Pension Plan compensation limit but limited to $1 million of compensation. The Pension Plan and SERP provide for vesting of contributions over a six-year employment period, after which all subsequent contributions are 100% vested. Employment Agreements and Arrangements; Change in Control Provisions Each of Messrs. Cochran and McCarthy entered into employment agreements with the Company, effective July 5, 2004. The employment agreements generally guarantee continuation of compensation and benefits through December 31, 2007, and provide for renewals and extensions of this initial term for two-year terms, subject to notice of termination from either party at least six months prior to the end of the extended term. At any point after the initial term has expired, Mr. Cochran may elect to become Non-Executive Chairman of the Company for the remainder of the term and any extensions. Under the agreements, compensation consists of: ·       base salary at the annual rate in effect immediately prior to the agreement, subject to increase at the Board’s discretion; ·       annual bonus equal to a minimum percentage of a “bonus pool” determined pursuant to formulae from time to time determined by the Human Resources Committee of the Board of Directors; and ·       annual awards of performance shares under the Company’s 1993 Equity Participation Plan, as amended (the “1993 Equity Plan”) and 2004 Equity Plan (together, the “Equity Plans”), having an estimated economic value at least equal to the employee’s 2004 performance shares award. Each performance share represents the economic value of up to two shares of common stock of the Company, and not just appreciation in share value, as is the case with a stock option. For additional information, see “—Equity Plans—Performance Shares.” The 2005 bonus pool guidelines contemplated a bonus pool equal to 11.25% of the growth in adjusted book value for the year, including a return on equity modifier. A similar guideline is expected to apply in 2006. An additional reserve bonus pool made up of previously earned but undistributed bonus pool allocations from prior years, equal to approximately $25.3 million after giving effect to 2005 bonuses (paid in the first quarter of 2006), could also be distributable. Messrs. Cochran and McCarthy are entitled to receive an annual cash bonus equal to at least 5.0% and 4.0%, respectively, of the bonus pool. The employment agreements provide that an additional 2.0% of the bonus pool will be allocated among those two executive officers as determined by the Human Resources Committee. 126    The employment agreements provide that Messrs. Cochran and McCarthy may elect to retire at age 60, but that retirement is mandatory at age 65. Upon retirement, each of Mr. Cochran and Mr. McCarthy will be entitled to his pro-rata annual base salary and annual bonus through the date of retirement and the vesting of his outstanding performance shares over time as if he remained employed. Messrs. Cochran and McCarthy are not entitled to any on-going retirement compensation except as provided by the Company’s defined contribution  Pension Plan and SERP. The employment agreements provide for continued participation in the Company’s benefit plans and severance benefits in lieu of the Company’s existing severance policy. Specifically, if the Company terminates Mr. Cochran or Mr. McCarthy without cause or either of such executive officers terminates his employment for “good reason,” he will be entitled to: ·       his pro-rata annual base salary and annual bonus through the date of termination; ·       twice his annual base salary at the rate then in effect and twice his average annual bonus for the two immediately prior years; ·       vesting of his outstanding performance shares; and ·       the minimum annual performance shares that he is entitled to receive through the end of the contract’s term. “Good reason” includes, for Mr. McCarthy, not being named Mr. Cochran’s successor as Chief Executive Officer of the Company. Both employment agreements provide that, if the employee is terminated for cause or terminates his employment without “good reason” during the term, he will be entitled only to be paid his pro rata annual base salary through the date of termination. If such termination occurs after the term of the agreement, he will also be entitled to his pro-rata annual bonus through the date of termination and his performance shares will vest pro rata in proportion to the percentage of the applicable performance cycle during which he was employed by the Company. Each employment agreement contains a non-compete provision extending through the greater of two years and the term of the agreement. If Mr. Cochran becomes Non-Executive Chairman of the Company, he will be entitled to his then-current salary and an annual performance share unit award with an estimated economic value at least equal to 50% of normal prior awards. If Mr. McCarthy becomes the Chief Executive Officer of the Company, he will be entitled to compensation equal to 90% or more of Mr. Cochran’s latest compensation, including salary, bonus and performance share units. The Company’s severance policy for senior management entitles Messrs. Brewer, Simon and Stern to 12 months of compensation, in each case, if terminated without cause and based on current salary and bonus (or, in certain events, prior compensation if higher). The severance policy provides reimbursement (on a grossed-up basis) for any “golden parachute” excise taxes payable by employees upon their termination of employment. The Equity Plans provide for accelerated vesting and payment of performance shares and restricted stock of Dexia awarded under the 2004 Equity Plan, if any, upon the occurrence of certain change in control transactions involving the Company. These provisions are generally applicable to all participants in the Equity Plans. Each of the named executive officers holds performance shares and Dexia restricted stock awarded under the Equity Plans. The 1993 Equity Plan provides that the Company’s Board of Directors may elect to continue the plan and the 2004 Equity Plan provides that the plan shall automatically continue if a change in control occurs. Following a “plan continuation,” performance shares and Dexia restricted stock are not accelerated, but vest and are payable as if no change in control had occurred, except in the case of any employee who is terminated without cause or leaves for “good reason” following the change in control. 127    Compensation of Directors Each director of the Company who is not an officer of the Company or Dexia received a fee of $50,000 per annum for service as a director and an additional annual fee of $20,000 if Chairman of the Underwriting Committee or Audit Committee of the Board of Directors or $5,000 if Chairman of another Committee of the Board of Directors. Each director also received $2,000 for each Board meeting and regular Committee meeting attended and reimbursement for expenses for each such meeting attended. Each director is entitled to defer fees under the Company’s Deferred Compensation Plan (the “DCP”) and to participate in the director share purchase program. Director Share Purchase Program In the fourth quarter of 2000, the Company entered into an agreement with Dexia Holdings and Dexia Public Finance Bank, now Dexia Crédit Local, to establish the Director Share Purchase Program, pursuant to which Company directors could invest in shares of the Company’s common stock. The Director Share Purchase Program entitles each director of the Company to purchase from Dexia (or an affiliate thereof) up to 126,958 restricted shares of the Company’s common stock (which represented a $10 million investment at the purchase price at inception of the program) at a price determined in accordance with the formula described below, provided that: ·       restricted shares must be held for the lesser of four years or the participant’s tenure as a director of the Company; ·       restricted shares may be put to Dexia Crédit Local at any time or from time to time following the required holding period for cash; and ·       purchases of shares after inception of the program are at a price equal to the purchase price for shares put to Dexia Crédit Local described below. Directors may purchase such shares either directly or through deemed investments under the DCP or SERP. Each deemed investment election with respect to these shares is irrevocable. The Director Share Purchase Program enables the Company to purchase from Dexia Holdings, at the same price, the same number of shares of common stock purchased by directors through phantom investments under the DCP or SERP. Upon expiration of any applicable deferral period, the Company is obligated to pay out the phantom investments in shares of common stock, which must be held by the participant as if acquired directly from Dexia Holdings for generally a minimum of six months. The purchase price for each restricted share acquired by a director or put to Dexia Crédit Local is equal to the product of 1.4676 and adjusted book value per share (“ABV per share”), with ABV per share determined in accordance with the methodology employed for valuing performance share award payouts under the Equity Plans. The purchase price per share, determined pursuant to such formula, was $178.00 as of December 31, 2005. ABV per share is measured at the close of the calendar quarter in which a director submits a repurchase notice, provided that ABV per share for a terminated director freezes at the end of the calendar quarter including the first anniversary of the later of the termination of directorship or, in the case of deferred shares, receipt of shares upon expiration of the deferral period. Sales under the program are not registered under the Securities Act in reliance upon an exemption from registration under Section 4(2) of that Act. None of the directors made any additional direct or phantom investments under the Director Share Purchase Program during 2003, or any direct investments after 2002, the year of inception of the Program. During 2004, one director invested in 1,890 phantom shares and during 2005 one director purchased 6,199 shares outright. For more information regarding the directors’ share ownership, see “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Directors and Executive Officers.” 128     Equity Plans In November 2004, the Company adopted the 2004 Equity Plan, to be used for equity compensation awards to Company executives and employees in lieu of the 1993 Equity Plan. The 2004 Equity Plan provides for awards of: ·       performance shares, ·       Dexia restricted stock, and ·       performance share units comprised of performance shares and Dexia restricted stock. The following table sets forth a summary of the performance share units awarded to each of the named executive officers for the year ended December 31, 2005 (which awards were made in February 2006), as well as the number of performance shares and Dexia restricted shares the awards were comprised of:     Name               Number of   Performance   Share Units               Number of Performance Shares   (“PS”) and Dexia Restricted Shares         Robert P. Cochran           34,000           Comprised of:       30,600 PS and 19,591   Dexia shares         Séan W. McCarthy           25,000           Comprised of:       22,500 PS and 14,405   Dexia shares         Bruce E. Stern           9,000           Comprised of:       8,100 PS and 5,186 Dexia   shares         Russell B. Brewer   II           9,000           Comprised of:       8,100 PS and 5,186 Dexia   shares         Joseph W. Simon           9,000           Comprised of:       8,100 PS and 5,186 Dexia shares           Performance Shares Each performance share represents the economic value of up to two shares of common stock of the Company, and not just appreciation, as is the case with a stock option. The number of shares of common stock actually earned for each performance share depends upon the attainment by the Company and its subsidiaries (on a consolidated basis) of “performance objectives” during the time period specified by the Committee at the time an award of performance shares is made. Both Equity Plans authorize the discretionary grant of performance shares by the committee administering the Equity Plan (the Human Resources Committee) to key employees of the Company and its subsidiaries. So long as the Company’s common stock is not registered under the Exchange Act, the Company expects to pay its performance shares in cash rather than stock. Since its inception, up to 3,300,000 shares of common stock have been available for distribution under the 2004 Equity Plan in respect of performance shares. Such shares may be newly issued shares, treasury shares or shares purchased in the open market. If performance shares awarded under the 2004 Equity Plan are forfeited, the shares allocated to such awards are again available for distribution in connection with future awards under the Plan. The following table sets forth (a) a summary of performance shares awarded to each of the named executive officers for the year ended December 31, 2005 (which awards were made in February 2006), (b) the applicable performance period until payout and (c) the related estimated future payouts at the stated assumed annual rates of adjusted book value per share and book value per share growth. 129    Long-Term Incentive Plans Awards in 2005(1)             Performance       Performance       Estimated Future Payouts(3)         Name       Shares   Awarded       Period Until   Payout       Threshold   (no. of shares)       Target   (no. of shares)       Maximum   (no. of shares)         Robert P. Cochran           30,600               (2   )           0               30,600               61,200             Séan W. McCarthy           22,500               (2   )           0               22,500               45,000             Bruce E. Stern           8,100               (2   )           0               8,100               16,200             Russell B. Brewer   II           8,100               (2   )           0               8,100               16,200             Joseph W. Simon           8,100               (2   )           0               8,100               16,200              (1)          These performance shares were awarded under the 2004 Equity Plan in February 2006 for the year ended December 31, 2005. The table excludes performance shares awarded in February 2005 for the year ended December 31, 2004, which are set forth in “Item 12. Security Ownership of Certain Beneficial Owners and Management—Performance Shares” of the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004. (2)          One-third of each award relates to the three-year performance cycle ending December 31, 2008 and two-thirds of each award relates to the three-year performance cycle ending December 31, 2009. Awards are payable shortly following completion of the applicable performance cycle, subject to earlier payment in certain circumstances or to deferral. Such performance shares vest at the completion of the applicable performance cycle, subject to rules pertaining to the recipient’s death, disability, retirement or termination of employment, or change-in-control transactions. (3)          The actual dollar value received by a holder of performance shares, in general, varies in accordance with the average of the annual rate of growth in “adjusted book value” and “book value” per share (“ROE”) of common stock during an applicable “performance cycle” and the value of common stock at the time of payout of such performance shares. For purposes of the foregoing, adjusted book value per share and book value per share are adjusted to exclude the after-tax change in accumulated other comprehensive income. Accumulated other comprehensive income includes, for example, unrealized gains and losses in the Company’s Investment Portfolio. With respect to the performance shares described in the table above, (a) if ROE is 7% or less per annum for any performance cycle, no shares of common stock will be earned for the performance cycle; (b) if ROE is 13% per annum for any performance cycle, a number of shares of common stock equal to 100% of the number of performance shares will be earned for that performance cycle; and (c) if ROE is 19% per annum or higher for any performance cycle, a number of shares of common stock equal to 200% of the number of performance shares will be earned for that performance cycle. If ROE is between 7% and 19%, the payout percentage will be interpolated. So long as the Company’s common stock is not publicly traded, the Company expects to pay its performance shares in cash rather than stock, with shares valued at the greater of (1) 0.85 times “adjusted book value” per share and (2) the average of (a) 1.15 times “adjusted book value” per share and (b) 14 times “operating earnings” per share (each such term as defined in the Equity Plans). At December 31, 2005, the estimated present value of one performance share at a one-times payout was $139.00 per share. Dexia Restricted Stock The 2004 Equity Plan authorizes the discretionary grant of Dexia restricted stock by the Human Resources Committee, the committee administering the Equity Plan, to the employees of the Company and its subsidiaries. Dexia restricted stock awarded under the 2004 Equity Plan represents ordinary shares of Dexia subject to certain vesting requirements and restrictions on transfer. Holders of Dexia restricted stock are entitled to receive all dividends paid on such stock from the date of grant. 130    The following table sets forth a summary of Dexia restricted stock awarded to each of the named executive officers for the year ended December 31, 2005 (which awards were made in February 2006) as a component of Performance Share Units. Dexia Restricted Stock Awarded For 2005     Name               Dexia   Restricted   Shares   Awarded         Robert P. Cochran           19,591             Séan W. McCarthy           14,405             Bruce E. Stern           5,186             Russell B. Brewer   II           5,186             Joseph W. Simon           5,186               For additional information regarding awards of Dexia restricted stock, see note (3) to the table entitled “Summary Compensation Table,” above. Compensation Committee Interlocks and Insider Participation The Human Resources Committee consisted of Messrs. Maxwell (Chairman), Cochran, Deletre, Downey, Richard and Taylor during 2005. In February 2006, Mr. Downey was named Chairman of the Committee, Axel Miller was elected to the Committee, and Messrs. Maxwell and Richard ceased to be members. Except for Messrs. Cochran and Taylor, none of such persons is currently or has ever been an officer or employee of the Company or any subsidiary of the Company. Mr. Richard is the Chairman of the Board of Directors of Dexia, Mr. Miller is the Group Chief Executive Officer and Chairman of the Management Board of Dexia, and Mr. Deletre is a member of the Executive Board of Dexia Crédit Local. As described in “Director Share Purchase Program,” above, members of the Human Resources Committee are entitled to participate in a share purchase program available to all directors of the Company, either directly or through deemed investments under the Company’s DCP or SERP. Item 12.                 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. 5% Shareholders The following table sets forth certain information regarding beneficial ownership of the Company’s equity at March 15, 2006 as to each person known by the Company to beneficially own, within the meaning of the Exchange Act, 5% or more of the outstanding shares of the common stock, par value $.01 per share, of the Company.     Title of class               Name and address of   beneficial owner       Amount and nature of   beneficial ownership       Percent of   class         Common stock, par   value        Dexia   S.A.(1)       32,871,753 shares(1)(2)           98.8   %(2)         $.01 per share       7 à 11 quai André   Citröen BP-1002                                         75 901 Paris Cedex 15,   France                                         Boulevard Pachéco   44   B-1000 Brussels, Belgium                                  (1)          Shares are held indirectly through a subsidiary of Dexia. (2)          For purposes of this table, Dexia is not deemed to be the beneficial owner of 254,756 shares acquired by the Company in connection with the Director Share Purchase Program described in “Item 11.  131    Executive Compensation—Director Share Purchase Program.” Ownership percentage is calculated based on 33,263,259 shares of common stock outstanding at March 15, 2006, which excludes such shares acquired by the Company. Directors and Executive Officers Ownership of Company Common Stock The following table sets forth certain information regarding beneficial and economic ownership of the Company’s common stock at March 15, 2006 for (a) each director of the Company, (b) each executive officer named under “Executive Compensation Summary Compensation Table” and (c) all executive officers and directors of the Company as a group. Beneficial ownership is less than 1% for each executive officer and director listed, individually and as a group.     Directors and Executive Officers               Amount and   Nature   of Beneficial   Ownership(1)       Economic   Ownership(1)         Dirk Bruneel(2)           —               —             Robert P. Cochran           41,744               253,491             Bruno Deletre(2)           —               —             Robert N. Downey           20,159               29,259             Jacques   Guerber(2)           —               —             Séan W. McCarthy           —               116,719             David O. Maxwell           6,009               19,299             Axel Miller(2)           —               —             James H. Ozanne           —               24,591             Pierre Richard(2)           —               —             Roger K. Taylor           —               96,489             George U. Wyper           6,199               6,199             Rembert von   Lowis(2)           —               —             Bruce E. Stern           —               32,867             Russell B. Brewer   II           —               32,867             Joseph W. Simon           —               25,633             All executive officers   and directors as a group (15 persons)           74,111               637,414              (1)          Shares beneficially owned were acquired under the Company’s Director Share Purchase Program described under “Item 11. Executive Compensation—Director Share Purchase Program.” To the extent shares economically owned exceed shares beneficially owned, such economic ownership is attributable to (a) deemed investments in the Company’s common stock under the Director Share Purchase Program, and  (b) performance shares, with each performance share treated as one share of common stock, in the amounts shown below (excluding fractional shares):     Officer               Performance Shares         Robert P. Cochran           126,533             Séan W. McCarthy           90,667             Bruce E. Stern           32,867             Russell B. Brewer   II           32,867             Joseph W. Simon           25,633               132    In December 2000, the Company acquired 301,095 shares of its common stock from Dexia Holdings to satisfy most of its obligations under the Director Share Purchase Program in an amount equal to the number of shares deemed invested by directors at the Program’s inception date under the DCP and SERP. The Company held 254,736 of those shares as of December 31, 2005. (2)          Messrs. Bruneel, Deletre, Guerber, Miller, Richard and von Lowis are directors of the Company and officers of Dexia or its subsidiaries. Dexia indirectly owns 98.8% of the Company’s common stock. The Company is not aware of any arrangements that may result in a change in control of the Company. Ownership of Dexia Common Stock The following table sets forth beneficial ownership of common shares of the Company’s parent, Dexia, at March 15, 2006, for (a) each director of the Company, (b) each executive officer and (c) all executive officers and directors of the Company as a group. Beneficial ownership is less than 1% for each executive officer and director listed, individually and as a group.     Directors and Executive Officers(1)               Amount and Nature of   Beneficial Ownership         Dirk Bruneel           42,429             Robert P.   Cochran(2)           743,679             Bruno Deletre           1,189             Robert N. Downey           —             Jacques Guerber           8,994             Séan W.   McCarthy(2)           613,599             David O. Maxwell           —             Axel Miller           200             James H. Ozanne           —             Pierre Richard           40,210             Roger K. Taylor           247,750             George U. Wyper           —             Rembert von Lowis           75,372             Bruce E. Stern(2)           225,115             Russell B. Brewer   II(2)           223,555             Joseph W. Simon(2)           42,005             All executive officers   and directors as a group (15 persons)           2,264,097              (1)          Dexia has provided the Company with information regarding shares owned by Messrs. Bruneel, Deletre, Guerber, Miller, Richard and von Lowis, and has advised the Company that: (a)          shares presented for those directors include only shares owned directly by such directors or shares for which those directors can cast a vote and exclude warrants, and (b)         as of December 31, 2005, the total number of outstanding Dexia shares was 1,107,469,030, so that together the Company’s executive officers and directors owned 0.20% of Dexia shares and the maximum amount owned by any of the Company’s executive officers and directors represents 0.07% of Dexia shares. A majority of the shares set forth above were acquired under the Employee Share Plans sponsored by Dexia from 2000 to 2005. All employees of the Company were allowed to participate in these plans. The number of shares an employee is entitled to purchase under these plans is a function of the employee’s compensation for the prior year of service. These plans allowed employees to purchase ordinary shares of Dexia stock at a 15% to 20% discount from market value, but restricted the ability to dispose of such shares for a five-year period following purchase, subject to limited exceptions. Shares purchased under these plans include shares acquired under “leveraged options.” Employees who purchased shares under the leveraged  133    options are entitled to the upside from ten shares for each share purchased with his or her own funds and benefit from a “floor” guarantying a return of invested funds following expiration of the five-year investment period. A third party financial institution is entitled to (1) all dividends paid on the leveraged shares and (2) a specified percentage of any share appreciation during the five-year investment period in the case of the “standard” leveraged option, and of the average monthly share appreciation during a 52-month period commencing six months after inception of the five-year investment period in the case of the “average” leveraged option. These percentages are as follows:  38% (for 2001), 40% (for 2002), 40% (for 2003 for the standard leveraged option), 20% (for 2003 for the average leveraged option), 35% (for 2004 for the standard leveraged option), 15% (for 2004 for the average leveraged option), 20% (for 2005 for the standard leveraged option) and 0.5% (for 2005 for the average leveraged option).     Officer               Leveraged Shares         Robert P. Cochran           709,280             Séan W. McCarthy           584,730             Bruce E. Stern           206,650             Russell B. Brewer   II           209,050             Joseph W. Simon           32,190               (2)          Includes shares granted under the 2004 Equity Plan, as described in “Item 11. Executive Compensation—Equity Plans.” Generally, one third of an award of Dexia restricted stock vests after 2.5 years and two thirds vests after 3.5 years, with transfer restrictions lapsing on one third of each award after three years and on two thirds of each award after four years. Securities Available Under Equity Compensation Plans The following table sets forth information as of December 31, 2005 with respect to each compensation plan of the Company under which equity securities of the Company are authorized for issuance. Equity Compensation Plan Information     Plan Catebgory               Number of securities   to be issued upon   exercise of   outstanding options,   warrants and   rights(a)       Weighted average   exercise price of   outstanding options,   warrants and rights(b)       Number of securities   remaining available   for future issuance under   equity compensation plans   (excluding securities   reflected in column (a))(c)         Equity compensation plans   approved by security holders(1)           0               Not applicable               2,698,200   (3)         Equity compensation   plans not approved by security holders(2)           —               —               —             Total           0               Not applicable               2,698,200              (1)          The Company currently maintains one such plan, the 2004 Equity Plan. A second plan, the Director Share Purchase Program, permits each director of the Company to purchase, directly from Dexia Holdings or through “phantom” investments in the Company’s DCP or SERP, up to 126,958 shares of common stock. However, such shares are already issued and outstanding. As of December 31, 2005, there were 1,194,649 shares available under the Director Share Purchase Program, based on the number of directors as of December 31, 2005 (12) and deducting shares that have already been purchased. See  “Item 11. Executive Compensation” for further discussion of these plans. (2)          All of the Company’s equity compensation plans have been approved by the Company’s shareholders. (3)          Shares available for future issuance under the 2004 Equity Plan. Since its inception, up to 3,300,000 shares of common stock have been available for distribution under the 2004 Equity Plan in respect of performance shares. Such shares may be newly issued shares, treasury shares or shares purchased in the open market.  If performance shares awarded under the 2004 Equity Plan are forfeited, the shares allocated to such awards are again available for distribution in connection with future awards under the Plan. So long as the Company’s common stock is not registered under the Exchange Act, the Company expects to pay its performance shares in cash rather than stock. 134
Controls and Procedures       116
Other Information       117     PART III
Directors and Executive Officers of the Registrant       118
Executive Compensation       124
Security Ownership of Certain Beneficial Owners and   Management and Related Stockholder Matters       131
2005       2004         Audit       $   2,033.9       $   1,084.5         Audit related       392.1       367.7         Tax       328.0       536.1         Total       $   2,754.0       $   1,988.3           Audit fees for the years ended December 31, 2005 and 2004 were for professional services rendered for the audits of the Company’s Consolidated Financial Statements, audits of the Subsidiaries, and issuance of consents. Included in this amount is $0.2 million and $0.2 million in fees relating to consents that are reimbursed to the Company by the issuers of FSA-insured deals for the years ended December 31, 2005 and 2004, respectively. Audit related fees for the years ended December 31, 2005 and 2004 were for assurance and related services related to the Company’s retirement plans and consultations concerning financial accounting and reporting standards. Tax fees for the years ended December 31, 2005 and 2004 were for services related to tax compliance, including the preparation of tax returns for expatriates, assistance with tax audits and appeals, and tax services for employee benefit plans. Audit Committee Pre-Approval Policies and Procedures The Audit Committee of the Company’s Bond of Directors pre-approves all audit and non-audit related fees paid to the Company’s auditors. 135     PART IV Item 15.   Exhibits, Financial Statement Schedules. 1.   Consolidated Financial Statements Item 8 sets forth the following financial statements of Financial Security Assurance Holdings Ltd. and Subsidiaries:     Report of Independent Registered Public Accounting   Firm       73         Consolidated   Balance Sheets at December 31, 2005 and 2004       74         Consolidated Statements of Operations and   Comprehensive Income for the Years Ended December 31, 2005, 2004 and   2003       75         Consolidated Statements of Changes in Shareholders’   Equity for the Years Ended December 31, 2005, 2004 and 2003       76         Consolidated Statements of Cash Flows for the Years   Ended December 31, 2005, 2004 and 2003       77         Notes to Consolidated Financial Statements       79           2.   Financial Statement Schedules The following financial statement schedule is filed as part of this Report.     Schedule       Title     II       Parent Company Condensed   Financial Information at December 31, 2005 and 2004 and for the Years   Ended December 31, 2005, 2004 and 2003.             The report of the   Independent Registered Public Accounting Firm with respect to the above   listed financial statement schedule is set forth under Item 8 of this Report.             All other   schedules are omitted because they are either inapplicable or the required   information is presented in the Consolidated Financial Statements of the   Company or the notes thereto.       3.   Exhibits The following are annexed as exhibits to this Report:     Exhibit No.       Exhibit     2.1       Agreement and   Plan of Merger dated as of March 14, 2000 by and among Dexia S.A.,   Dexia Crédit Local de France S.A., PAJY Inc. and the Company.   (Previously filed as Exhibit 2.1 to Current Report on Form 8-K   (Commission File No. 1-12644) dated March 14, 2000, and   incorporated herein by reference.)     3.1       Restated   Certificate of Incorporation of the Company. (Previously filed as   Exhibit 3.1 to the Company’s Registration Statement on Form S-3   (Reg. No. 333-74165) (the “Form S-3”), and incorporated   herein by reference.)     3.1(A)       Certificate of   Merger of PAJY Inc. into the Company under Section 904 of the Business   Corporation Law of the State of New York (effective July 5, 2000).   (Previously filed as Exhibit 3.1 to the Company’s Quarterly Report on   Form 10-Q (Commission File No. 1-12644) for the   quarterly period ended September 30, 2000 (the “September 30, 2000   10-Q”), and incorporated herein by reference.)     3.1(B)       Certificate of   Merger of White Mountains Holdings, Inc. and the Company into the   Company under Section 904 of the Business Corporation Law (effective   July 5, 2000). (Previously filed as Exhibit 3.2 to the   September 30, 2000 10-Q, and incorporated herein by reference.)     136          3.2       Amended and   Restated By-laws of the Company, as amended and restated on   July 5, 2000. (Previously filed as Exhibit 3.3 to the   September 30, 2000 10-Q, and incorporated herein by reference.)     4.1       Amended and   Restated Trust Indenture dated as of February 24, 1999 (the “Amended and   Restated Senior Indenture”) between the Company and the Senior Debt Trustee.   (Previously filed as Exhibit 4.1 to the Company’s Registration Statement   on Form S-3 (Reg. No. 33-74165), and incorporated   herein by reference.)     4.1(A)       Form of 67¤8%   Quarterly Interest Bond Securities due December 15, 2101. (Previously   filed as Exhibit 2 to the Company’s Current Report on Form 8-K   (Commission File No. 1-12644) dated December 12, 2001 (the   “December 2001 Form 8-K”), and incorporated herein by   reference.)     4.1(B)       Officers’   Certificate pursuant to Sections 2.01 and 2.03 of the Amended and Restated   Senior Indenture. (Previously filed as Exhibit 3 to the   December 2001 Form 8-K, and incorporated herein by reference.)     4.1(C)       Form of   6.25% Notes due 2102. (Previously filed as Exhibit 3 to the Company’s   Current Report on Form 8-K (Commission File No. 1-12644)   dated November 6, 2002 and filed November 25, 2002 (the   “November 2002 Form 8-K”), and incorporated herein by   reference.)     4.1(D)       Officers’   Certificate pursuant to Sections 2.01 and 2.03 of the Amended and   Restated Senior Indenture. (Previously filed as Exhibit 4 to the   November 2002 Form 8-K, and incorporated herein by   reference.)     4.1(E)       Form of   5.60% Notes due 2103. (Previously filed as Exhibit 2 to the Company’s   Current Report on Form 8-K (Commission File No. 1-12644)   dated July 17, 2003 and filed July 30, 2003 (the “July 2003   Form 8-K”), and incorporated herein by reference.)     4.1(F)       Officers’   Certificate pursuant to Sections 2.01 and 2.03 of the Amended and   Restated Senior Indenture. (Previously filed as Exhibit 3 to the   July 2003 Form 8-K, and incorporated herein by reference.)     10.1       Credit Agreement   dated as of August 31, 1998 among FSA, each of its insurance company   affiliates listed on Schedule I attached thereto, the Banks from time to   time party thereto and Deutsche Bank AG, New York Branch, as agent.   (Previously filed as Exhibit 10 to the Company’s Quarterly Report on   Form 10-Q (Commission File No. 1-12644) for the   quarterly period ended September 30, 1998, and incorporated herein by   reference.)     10.1(A)       Amendment   No. 7 to the Credit Agreement, dated as of April 22, 2005, among   Financial Security Assurance Inc., the additional borrowers party thereto,   various banks, JPMorgan Chase Bank, N.A. and The Bank of New York, as agent. (Previously filed as Exhibit 10.1 to the   Company’s Quarterly Report on Form 10-Q (Commission File   No. 1-12644) for the quarterly period ended March 31, 2005   (the “March 31, 2005 10-Q”), and incorporated herein by   reference.)     10.2       Third Amended and   Restated Credit Agreement dated as of April 30, 2005, among Financial   Security Assurance Inc., FSA Insurance Company, the Banks party thereto from   time to time and Bayerische Landesbank, acting through its New York Branch,   as Agent. (Previously filed as   Exhibit 10.2 to the March 31, 2005 10-Q, and incorporated   herein by reference.)     10.3†       1989 Supplemental Executive Retirement Plan (amended   and restated as of December 17, 2004). (Previously filed as   Exhibit 10.4 to the Company’s Current Report on Form 8-K   (Commission File No. 1-12644) dated December 17, 2004 and   filed on December 17, 2004 (the “December 2004 Form 8-K”),   and incorporated herein by reference.)     137          10.4†       2004 Supplemental   Executive Retirement Plan, dated as of December 17, 2004. (Previously   filed as Exhibit 10.3 to the December 2004 Form 8-K, and   incorporated herein by reference.     10.5†       Amended and   Restated 1993 Equity Participation Plan (amended and restated as of May 17,   2001). (Previously filed as Exhibit 10.1 to the Company’s Quarterly   Report on Form 10-Q (Commission File No. 1-12644) for   the quarterly period ended June 30, 2001 (the “June 30, 2001 10-Q”),   and incorporated herein by reference.)     10.6†       2004 Equity Participation   Plan (Previously filed as Exhibit 10.1 to the Company’s current report   on Form 8-K (Commission File No. 1-12644) dated   November 18, 2004 and filed on November 23, 2004 (the   “November 2004 Form 8-K”) and incorporated herein by   reference.)     10.6A†       2004 Equity   Participation Plan, as amended on September 15, 2005. (Previously filed   as Exhibit 10.1 to Current Report on Form 8-K (Commission   File No. 1-12644) dated September 16, 2005, and incorporated   herein by reference.)     10.6B†       2004 Equity   Participation Plan, as amended on February 16, 2006. (Previously filed   as Exhibit 10.1 to Current Report on Form 8-K (Commission   File No. 1-12644) dated February 16, 2006 (the   “February 16, 2006 8-K”), and incorporated herein by reference.)     10.6C†       Form of Financial   Security Assurance Holdings Ltd. Agreement Evidencing an Award of Dexia   Restricted Stock. (Previously filed as   Exhibit 10.4 to the March 31, 2005 10-Q, and incorporated   herein by reference.)     10.6D†       Form of   Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award of   Dexia Restricted Stock, as amended on February 16, 2006. (Previously filed as Exhibit 10.2 to the   February 16, 2006 8-K, and incorporated herein by reference.)     10.6E†       Form of   Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award   of Performance Shares. (Previously filed as Exhibit 99.1 to the Current   Report on Form 8-K (Commission File No. 1-12644) dated   February 16, 2005, and incorporated herein by reference.)     10.6F†       Form of   Financial Security Assurance Holdings Ltd. Agreement Evidencing an Award   of Performance Shares, as amended on February 16, 2006. (Previously filed as Exhibit 10.3 to the   February 16, 2006 8-K, and incorporated herein by reference.)     10.7†       Financial   Security Assurance Inc. Overseas Pension Plan. (Previously filed as   Exhibit 10.3 to the February 16, 2006 8-K, and incorporated   herein by reference.)     10.8†       1995 Deferred   Compensation Plan (amended and restated as of December 17, 2004).   (Previously filed as Exhibit 10.2 to the December 2004 8-K,   and incorporated herein by reference.)     10.9†       2004 Deferred   Compensation Plan, dated December 17, 2004. (Previously filed as   Exhibit 10.1 to the December 2004 8-K, and incorporated   herein by reference.)     10.10†       Severance Policy   for Senior Management (amended and restated as of November 13, 2003).   (Previously filed as Exhibit 10.7 to the Company’s Annual Report on   Form 10-K (Commission File No. 1-12644) for the fiscal   year ended December 31, 2003, and incorporated herein by reference.)     10.11†       Share Purchase Program Agreement dated as of   December 15, 2000, among Dexia Public Finance Bank, Dexia   Holdings, Inc. and the Company. (Previously filed as   Exhibit 10.9(B) to the Company’s Annual Report on Form 10-K   (Commission File No. 1-12644) for the fiscal year ended   December 31, 2000 (the “December 31, 2000 10-K”), and   incorporated herein by reference.)     138          10.12†       Employment   Agreement dated as of July 5, 2004 by and between the Company and   Robert P. Cochran. (Previously filed as Exhibit 10.1 to the Company’s   Quarterly Report on Form 10-Q (Commission File No. 1-12644)   for the quarterly period ended September 30, 2004 (the   “September 30, 2004 10-Q”), and incorporated herein by reference.)     10.13†       Employment   Agreement dated as of July 5, 2004 by and between the Company and Séan   W. McCarthy. (Previously filed as Exhibit 10.2 to the September 30,   2004 10-Q, and incorporated herein by reference.)     10.14†       Financial   Security Assurance Holdings Ltd. Annual Bonus Pool Guideline.   (Previously filed as Exhibit 10.3 to the September 30, 2004 10-Q,   and incorporated herein by reference.)     10.15       Put Option   Agreement, dated as of June 23, 2003 by and between FSA and Sutton   Capital Trust I. (Previously filed as Exhibit 99.5 to the Company’s   Quarterly Report on Form 10-Q (Commission File No. 1-12644)   for the quarterly period ended June 30, 2003 (the “June 30, 2003 10-Q”),   and incorporated herein by reference.)     10.16       Put Option   Agreement, dated as of June 23, 2003 by and between FSA and Sutton   Capital Trust II. (Previously filed as Exhibit 99.6 to the   June 30, 2003 10-Q, and incorporated herein by reference.)     10.17       Put Option   Agreement, dated as of June 23, 2003 by and between FSA and Sutton   Capital Trust III. (Previously filed as Exhibit 99.7 to the   June 30, 2003 10-Q, and incorporated herein by reference.)     10.18       Put Option   Agreement, dated as of June 23, 2003 by and between FSA and Sutton   Capital Trust IV. (Previously filed as Exhibit 99.8 to the   June 30, 2003 10-Q, and incorporated herein by reference.)     21*       List of Subsidiaries.     23*       Consent of   PricewaterhouseCoopers LLP.     24.1       Powers of   Attorney. (Previously filed as Exhibit 24 to the Company’s Annual Report   on Form 10-K (Commission File No. 1-12644) for the   fiscal year ended December 31, 2002 and as Exhibit 24.2 to the   Company’s Annual Report on Form 10-K (Commission File No. 1-12644)   for the fiscal year ended December 31, 2004, and incorporated herein by   reference.)     24.2       Power of   Attorney.*     31.1*       Certification   pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.     31.2*       Certification   pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.     32.1**       Certification   pursuant to 18 U.S.C. Section 1350, as adopted pursuant to   Section 906 of the Sarbanes-Oxley Act of 2002.     32.2**       Certification   pursuant to 18 U.S.C. Section 1350, as adopted pursuant to   Section 906 of the Sarbanes-Oxley Act of 2002.     99.1*       Financial   Security Assurance Inc. and Subsidiaries 2005 Consolidated Financial   Statements and Report of Independent Registered Public Accounting Firm.        *                    Filed herewith. **             Furnished herewith. †                     Management contract of compensatory plan or arrangement. 139     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.         FINANCIAL   SECURITY ASSURANCE HOLDINGS LTD.         By:   /s/ ROBERT P. COCHRAN             Name: Robert P. Cochran             Title: Chairman and   Chief Executive Officer             Dated: March 28,   2006       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.         Signature               Title               Date         /s/ ROBERT P.   COCHRAN       Chairman, Chief   Executive Officer and       March 28, 2006     Robert   P. Cochran       Director (Principal Executive Officer)             /s/ SÉAN W.   MCCARTHY       President, Chief   Operating Officer and       March 28, 2006     Séan   W. McCarthy       Director             /s/ JOSEPH W.   SIMON       Managing Director and   Chief Financial       March 28,   2006     Joseph   W. Simon       Officer (Principal Financial Officer)             /s/ LAURA A.   BIELING       Managing Director and   Controller        March 28,   2006     Laura   A. Bieling       (Principal Accounting Officer)             /s/ DIRK   BRUNEEL       Director       March 28,   2006     Dirk   Bruneel                     /s/ BRUNO   DELETRE       Director       March 28,   2006     Bruno   Deletre                     /s/ ROBERT N.   DOWNEY       Director       March 28,   2006     Robert   N. Downey                     /s/ JACQUES   GUERBER       Director       March 28,   2006     Jacques   Guerber                     140          /s/ DAVID O.   MAXWELL       Director       March 28,   2006     David   O. Maxwell                     /s/ AXEL   MILLER       Director       March 28,   2006     Axel   Miller                     /s/ JAMES H.   OZANNE       Director       March 28,   2006     James   H. Ozanne                     /s/ PIERRE   RICHARD       Vice Chairman and   Director       March 28,   2006     Pierre   Richard                     /s/ ROGER K.   TAYLOR       Director       March 28,   2006     Roger   K. Taylor                     /s/ REMBERT   VON LOWIS       Director       March 28,   2006     Rembert   von Lowis                     /s/ GEORGE U.   WYPER       Director       March 28,   2006     George U. Wyper                      *                    Robert P. Cochran, by signing his name hereto, does hereby sign this Annual Report on Form 10-K on behalf of himself and on behalf of each of the Directors and Officers of the Registrant named above after whose typed names asterisks appear pursuant to powers of attorney duly executed by such Directors and Officers and filed with the Securities and Exchange Commission as exhibits to this Report.            By:   /s/ ROBERT P. COCHRAN,                 Robert P. Cochran                 Attorney   in fact       141     Schedule II Parent Company Condensed Financial Information Condensed Balance Sheets (in thousands)             December 31,                 2005       2004         Assets:                         Bonds at market   value (amortized cost of $10,923 and $25,301)       $   11,158       $   25,684         Short-term   investments       47,140       220         Cash       1,895       1,058         Investment in   subsidiaries, at equity in net assets       3,052,478       2,868,797         Notes receivable   from subsidiary       108,850       108,850         Deferred   compensation       107,140       112,941         Deferred taxes       34,011       40,843         Due from subsidiaries       67       2,519         Other assets       40,836       39,343         Total Assets       $   3,403,575       $   3,200,255         Liabilities and   Shareholders’ Equity:                         Notes Payable       $   430,000       $   430,000         Other Liabilities       30,293       28,259         Due to   subsidiaries       2,832       5,317         Deferred   compensation       107,140       112,941         Taxes payable       10,408       12,460         Shareholders’   equity       2,822,902       2,611,278         Total Liabilities and   Shareholders’ Equity       $   3,403,575       $   3,200,255           Condensed Statements of Income (in thousands)             Year Ended December 31,                 2005       2004       2003         Investment Income       $   6,724       $   7,379       $   10,077         Net realized   gains (losses)       (395   )   497       (909   )     Other income   (loss)       2,152       18,138       27,287         Interest and   amortization expense       (26,993   )   (26,993   )   (33,026   )     Commissions       —       —       (703   )     Other expenses       (6,539   )   (18,451   )   (29,023   )     Net unrealized   gains (losses) on derivative instruments       (304   )   1,589       1,638                 (25,355   )   (17,841   )   (24,659   )     Equity in   undistributed net income of subsidiaries       332,719       368,139       313,789         Income before   taxes       307,364       350,298       289,130         Income tax   benefit       18,744       28,309       8,997         Net Income       $   326,108       $   378,607       $   298,127           The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8. 142    Condensed Statements of Cash Flows (in thousands)             Year Ended December 31,                 2005       2004       2003         Cash flows from   operating activities:                                 Other operating expenses   recovered (paid), net       $   (1,678   )   $   (1,271   )   $   (4,672   )     Net investment income   received       6,869       8,858       10,357         Federal income taxes   received (paid)       —       —       (3,504   )     Interest paid       (26,993   )   (26,850   )   (28,367   )     Other       (2,689   )   1,489       253         Net cash used for   operating activities       (24,491   )   (17,774   )   (25,933   )     Cash flows from   investing activities:                                 Proceeds from sales of   bonds       41,837       31,600       27,182         Purchases of bonds       (27,830   )   (36,103   )   (39,539   )     Dividend from subsidiary       87,000       30,000       7,857         Capital contribution       (5,700   )   (29,500   )   (37,500   )     Return of capital from   subsidiary       48,000       —       —         Net decrease (increase)   in short-term investments       (46,920   )   465       9,754         Other investments       —       —       1,000         Net cash used for investing   activities       96,387       (3,538   )   (31,246   )     Cash flows from   financing activities:                                 Issuance of notes   payable       —       —       96,673         Repayment of notes   payable       —       —       (100,000   )     Surplus notes redeemed   (purchased), net       —       44,000       60,000         Dividends paid       (71,059   )   (22,876   )   —         Net cash provided by   financing activities       (71,059   )   21,124       56,673         Net increase (decrease)   in cash       837       (188   )   (506   )     Cash at beginning of   year       1,058       1,246       1,752         Cash at end of year       $   1,895       $   1,058       $   1,246           In 2005, 2004 and 2003, the Company’s subsidiaries received a tax benefit of $4,624, $20,164 and $10,645, respectively, by utilizing the Company’s losses. These balances were recorded as capital contributions. The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8.             Year Ended December 31,                 2005       2004       2003         Reconciliation of net income to net cash provided by operating   activities:                                 Net income       $   326,108       $   378,607       $   298,127         Equity in undistributed   net income of subsidiary       (334,062   )   (368,139   )   (313,789   )     Decrease (increase) in   accrued investment income       154       1,373       11         Increase (decrease) in   accrued income taxes       (6,676   )   (10,821   )   (14,337   )     Provision (benefit) for   deferred income taxes       (12,166   )   (10,932   )   3,051         Net realized losses   (gains) on investments       395       (497   )   909         Accretion of bond   discount       (23   )   96       —         Change in other assets   and liabilities       1,779       (7,461   )   95         Cash used for operating activities       $   (24,491   )   $   (17,774   )   $   (25,933   )       The Parent Company Condensed Financial Information should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in Item 8. 143     SCHEDULE II Financial Security Assurance Holdings Ltd. (Parent Company) Notes to Condensed Financial Statements 1.                 Condensed Financial Statements Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. These condensed financial statements should be read in conjunction with the Company’s Consolidated Financial Statements and the notes thereto. Certain reclassifications have been made to conform to the current year presentation. 2.                 Significant Accounting Policies The Parent Company carries its investments in subsidiaries under the equity method. 3.                 Long-Term Debt On July 31, 2003, the Company issued $100.0 million principal amount of 5.60% Notes due July 15, 2103, which are callable without premium or penalty in whole or in part at any time on or after July 31, 2008. Debt issuance costs of $3.3 million are being amortized over the life of the Notes. In September 2003, the Company called for redemption, on November 1, 2003, $100.0 million of its 6.95% Senior Quarterly Income Debt Securities (“Senior QUIDS”) due November 1, 2098 and delivered to the trustee sufficient collateral to legally defease the 6.95% Senior QUIDS. Unamortized debt issuance costs of $3.2 million for the 6.95% Senior QUIDS were charged to interest expense in 2003. Subsequently, the trustee used the defeasance collateral to redeem all of the 6.95% Senior QUIDS. On November 26, 2002, the Company issued $230.0 million principal amount of 6.25% Notes due November 1, 2102, which are callable without premium or penalty in whole or in part at any time on or after November 26, 2007. Debt issuance costs of $7.4 million are being amortized over the life of the debt. The Company used a portion of the proceeds of this issuance to redeem in whole the Company’s $130.0 million principal amount of 7.375% Senior QUIDS due September 30, 2097. Unamortized debt issuance costs of the retired debt of $4.1 million were charged to interest expense in 2002. 4.                 Taxes In connection with the Dexia group’s acquisition of the Company in July 2000, the Company became the successor, for tax purposes, to White Mountains Holdings, Inc. (“WMH”). WMH had previously sold an insurance subsidiary to a third party that was indemnified by White Mountains Insurance Group for certain future adverse loss development up to $50.0 million. In 2004, the Company made an indemnity payment of $47.0 million to the third party with funds provided for such purpose by White Mountains Insurance Group. While the Company had no legal liability in connection with the indemnity payment, the payment should be treated for tax purposes as a $47.0 million loss deduction to the Company, as successor to WMH. The Company therefore recorded a deferred tax asset with a corresponding deferred tax benefit of $16.5 million. There can be no assurance that the deferred tax benefit will not be reversed in the future. In addition, the Company has agreed to share 50% of the deferred tax benefit with White Mountains Insurance Group under certain circumstances, but did not satisfy the standards for recording a liability for accounting purposes as of December 31, 2005. 144        EX-21 2 a06-6322_2ex21.htm SUBSIDIARIES OF THE REGISTRANT       EXHIBIT 21 SUBSIDIARIES OF FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. 1.                 Financial Security Assurance Inc. (incorporated in the State of New York) 2.                 Financial Security Assurance International Ltd. (incorporated in Bermuda) 3.                 Financial Security Assurance (U.K.) Limited (incorporated in the United Kingdom) 4.                 FSA Asset Management Services LLC (organized in the State of Delaware) 5.                 FSA Capital Markets Services LLC (organized in the State of Delaware) 6.                 FSA Capital Management Services LLC (organized in the State of Delaware) 7.                 FSA Global Funding Limited (incorporated in the Cayman Islands) 8.                 FSA Insurance Company (incorporated in the State of Oklahoma) 9.                 FSA Portfolio Management Inc. (incorporated in the State of New York) 10.          Transaction Services Corp. (incorporated in the State of New York)        EX-23 3 a06-6322_2ex23.htm CONSENTS OF EXPERTS AND COUNSEL       Exhibit 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We hereby consent to the incorporation by reference in the Registration Statement of Financial Security Assurance Holdings Ltd. on Form S-8 (File No. 33-78784) (1993 Equity Participation Plan) and Form S-8 (File No. 33-92648) (Deferred Compensation Plan) of: 1.                 Our report dated March 24, 2006, on our audits of the consolidated balance sheets of Financial Security Assurance Holdings Ltd. and Subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations and comprehensive income, changes in shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2005 and on our audits of the financial statement schedule relating to the consolidated financial statements of Financial Security Assurance Holdings Ltd. and Subsidiaries, which report is included in this Annual Report on Form 10-K for the fiscal year ended December 31, 2005.     /s/ PricewaterhouseCoopers LLP         New York, New York     March 24, 2006              EX-24.2 4 a06-6322_2ex24d2.htm POWER OF ATTORNEY       Exhibit 24.2 POWER-OF-ATTORNEY Annual Reports on Form 10-K of Financial Security Assurance Holdings Ltd. The undersigned, as a director of Financial Security Assurance Holdings Ltd., a New York corporation (the “Company”), and/or, as applicable, as an officer of the Company, does hereby constitute and appoint each of Robert P. Cochran, Séan W. McCarthy and Bruce E. Stern to be his agent and attorney-in-fact, with the power to act fully hereunder and with full power of substitution to act in the name and on behalf of the undersigned, (i) to sign in the name and on behalf of the undersigned, as a director and/or officer of the Company, as applicable, and file with the Securities and Exchange Commission, an Annual Report on Form 10-K for each fiscal year for which the Company is required to file such an Annual Report, and any amendments or supplements thereto, and (ii) to execute and deliver any instruments, certificates or other documents which he shall deem necessary or proper in connection with the filing of each such Annual Report on Form 10-K, and any such amendment or supplement thereto, and generally to act for and in the name of the undersigned with respect to each such filing as fully as could the undersigned if then personally present and acting. The foregoing Power-of-Attorney shall be in full force and effect for so long as the undersigned shall be a director or officer of the Company, as applicable, unless and until revoked as to the undersigned by written instrument delivered by him to the Secretary of the Company. IN WITNESS WHEREOF, the undersigned has duly executed this Power-of-Attorney on February 16, 2006.     /s/ AXEL MILLER     Axel Miller                EX-31.1 5 a06-6322_2ex31d1.htm 302 CERTIFICATION       Exhibit 31.1 CERTIFICATIONS I, Robert P. Cochran, Chief Executive Officer of Financial Security Assurance Holdings Ltd., certify that: 1.                I have reviewed this Annual Report on Form 10-K for the fiscal year ending December 31, 2005 of Financial Security Assurance Holdings Ltd.; 2.                Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3.                Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.                The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a)           Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b)          Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c)           Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5.                The registrant’s other certifying officers(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a)           All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b)          Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.    Date: March 28, 2006                     /s/ ROBERT P. COCHRAN             Name: Robert P. Cochran             Title: Chief Executive   Officer      1        EX-31.2 6 a06-6322_2ex31d2.htm 302 CERTIFICATION       Exhibit 31.2 CERTIFICATIONS I, Joseph W. Simon, Chief Financial Officer of Financial Security Assurance Holdings Ltd., certify that: 1.                I have reviewed this Annual Report on Form 10-K for the fiscal year ending December 31, 2005 of Financial Security Assurance Holdings Ltd.; 2.                Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3.                Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.                The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a)           Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b)          Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c)           Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5.                The registrant’s other certifying officers(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions): (a)           All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b)          Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.    Date: March 28, 2006                     /s/ JOSEPH W. SIMON             Name: Joseph W. Simon             Title: Chief Financial   Officer      1        EX-32.1 7 a06-6322_2ex32d1.htm 906 CERTIFICATION       Exhibit 32.1 Certification of Chief Executive Officer In connection with the Annual Report on Form 10-K for the fiscal year ending December 31, 2005 of Financial Security Assurance Holdings Ltd. (the “Company”), as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Robert P. Cochran, Chief Executive Officer of the Company, hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1.                The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2.                The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.       By:   /s/ ROBERT P. COCHRAN             Chief Executive   Officer             March 28,   2006      A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. 1        EX-32.2 8 a06-6322_2ex32d2.htm 906 CERTIFICATION       Exhibit 32.2 Certification of Chief Financial Officer In connection with the Annual Report on Form 10-K for the fiscal year ending December 31, 2005 of Financial Security Assurance Holdings Ltd. (the “Company”), as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Joseph W. Simon, Chief Financial Officer of the Company, hereby certify pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1.                The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2.                The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.       By:   /s/ JOSEPH W. SIMON             Chief Financial   Officer             March 28,   2006      A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. 1        EX-99.1 9 a06-6322_2ex99d1.htm EXHIBIT 99       Exhibit 99.1    FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES Consolidated Financial Statements and Report of Independent Registered Public Accounting Firm December 31, 2005     FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS AND REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003    REPORT OF INDEPENDENT   REGISTERED PUBLIC ACCOUNTING FIRM       1         CONSOLIDATED   FINANCIAL STATEMENTS:                 Consolidated Balance Sheets       2         Consolidated Statements of Operations and   Comprehensive Income.       3         Consolidated Statements of Changes in Shareholder’s   Equity.       4         Consolidated Statements of Cash Flows       5         Notes to   Consolidated Financial Statements       7          The New York State Insurance Department recognizes only statutory accounting practices for determining and reporting the financial condition and results of operations of an insurance company, for determining its solvency under the New York Insurance Law, and for determining whether its financial condition warrants the payment of a dividend to its stockholders. No consideration is given by the New York State Insurance Department to financial statements prepared in accordance with accounting principles generally accepted in the United States of America in making such determinations.     Report of Independent Registered Public Accounting Firm To Board of Directors and Shareholder of Financial Security Assurance Inc.: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations and comprehensive income, changes in shareholder’s equity, and cash flows present fairly, in all material respects, the financial position of Financial Security Assurance Inc. and Subsidiaries (the “Company”) at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note 20 to the consolidated financial statements, in 2003 the Company changed its method of accounting for its interest in certain variable interest entities.    /s/ PricewaterhouseCoopers LLP             New York, New York         March 24, 2006          1     FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (in thousands, except per share data)           As of                 December 31,   2005       December 31,   2004         ASSETS                                         Bonds at fair value   (amortized cost of $4,208,011 and $3,838,115)           $   4,370,469               $   4,089,911             Equity securities at   fair value (cost of $54,370 and $54,300)           54,370               54,300             Short-term investments           133,283               115,596             Variable interest   entities’ bonds at fair value (amortized cost of $1,155,832 and $1,342,489)           1,155,992               1,346,355             Variable interest   entities’ guaranteed investments contracts at fair value (amortized cost   approximates fair value)           1,021,791               961,925             Variable interest   entities’ short-term investment portfolio           2,674               1,194             Total investment   portfolio           6,738,579               6,569,281             Assets acquired in refinancing transactions:                                         Bonds at fair value   (amortized cost of $5,945 and $151,895)           9,145               157,036             Securitized loans           296,965               369,750             Other           161,763               222,150             Total assets acquired in   refinancing transactions           467,873               748,936             Cash           10,376               10,005             Deferred acquisition   costs           335,129               308,015             Prepaid reinsurance   premiums           865,192               759,191             Reinsurance recoverable   on unpaid losses           36,339               35,419             Other assets           1,162,562               1,125,619             TOTAL ASSETS           $   9,616,050               $   9,556,466             LIABILITIES   AND MINORITY INTEREST AND SHAREHOLDER’S EQUITY                                         Deferred premium revenue           $   2,380,600               $   2,101,248             Losses and loss   adjustment expenses           205,718               179,941             Variable interest   entities’ debt           2,708,773               2,853,963             Deferred federal income   taxes           238,342               253,772             Notes payable to   affiliate           463,575               753,614             Surplus notes           108,850               108,850             Minority interest           254,123               300,052             Accrued expenses and   other liabilities           353,643               307, 791             TOTAL LIABILITIES AND   MINORITY INTEREST           6,713,624               6,859,231             COMMITMENTS AND CONTINGENCIES                                         Preferred stock (5,000.1 and 0 shares authorized; 0   shared issued and outstanding; par value of $1,000 per share)                                         Common stock (400 shares   authorized; issued and outstanding; par value of $37,500 per share)           15,000               15,000             Additional paid-in   capital—common           841,828               839,077             Accumulated other   comprehensive income (net of deferred income taxes of $58,198 and $88,057)           108,082               170,620             Accumulated earnings           1,937,516               1,672,538             TOTAL SHAREHOLDER’S EQUITY           2,902,426               2,697,235             TOTAL LIABILITIES   AND MINORITY INTEREST AND SHAREHOLDER’S EQUITY           $   9,616,050               $   9,556,466                             The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 2     FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (in thousands)           Year Ended December 31,                 2005       2004       2003         REVENUES:                                 Net premiums written       $   604,411       $   602,903       $   621,824         Net premiums earned       $   431,059       $   410,439       $   363,913         Net investment income       199,227       170,942       153,071         Net realized gains (losses)       5,177       (970   )   5,195         Variable interest entities’ interest income       105,561       74,286       31,076         Net realized and unrealized gains (losses) on   derivative instruments        (124,851   )   304,843       228,208         Income from assets acquired in refinancing   transactions       35,183       31,634       20,705         Net realized gains from assets acquired in   refinancing transactions       6,508       —       —         Other income       13,463       6,365       1,235         TOTAL REVENUES       671,327       997,539       803,403         EXPENSES:                                 Losses and loss adjustment expenses       25,365       20,599       34,486         Interest expense       33,608       31,499       30,036         Variable interest entities’ interest expense       124,219       126,793       58,595         Policy acquisition costs       68,340       62,201       58,391         Variable interest entities’ foreign exchange (gain)   loss       (162,398   )   79,270       118,269         Other operating expenses       74,212       69,835       49,668         TOTAL EXPENSES       163,346       390,197       349,445         INCOME BEFORE   INCOME TAXES, MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED   AFFILIATES, AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE       507,981       607,342       453,958         Provision for income   taxes:                                 Current       128,611       62,489       83,044         Deferred       14,412       60,929       19,032         Total provision       143,023       123,418       102,076         NET INCOME BEFORE   MINORITY INTEREST, EQUITY IN EARNINGS OF UNCONSOLIDATED AFFILIATES, AND   CUMULATIVE EFFECT OF ACCOUNTING CHANGE       364,958       483,924       351,882         Minority interest       (12,980   )   (120,397   )   (52,153   )     Equity in   earnings of unconsolidated affiliates       —       3,761       19,077         Cumulative effect   of accounting change, net of income taxes of $2,598        —       —       4,800         NET INCOME       351,978       367,288       323,606         OTHER COMPREHENSIVE INCOME   (LOSS), NET OF TAX:                                 Unrealized gains (losses) arising during period [net   of deferred income tax provision (benefit) of $(36,635), $5,676 and $12,329]       (49,954   )   11,968       18,929         Less: reclassification adjustment for gains (losses)   included in net income [net of deferred income tax provision (benefit) of   $6,776, $(542) and $1,389]           12,584       (428   )   3,965         Other comprehensive income (loss)       (62,538   )   12,396       14,964         COMPREHENSIVE INCOME       $   289,440       $   379,684       $   338,570          The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 3     FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER’S EQUITY (in thousands)             Common   Stock       Additional   Paid-In   Capital-   Common       Unrealized   Gain on   Investments       Accumulated   Earnings       Total         BALANCE, December 31, 2002       $   15,000       $   813,002           $   143,260           $   1,011,644       $   1,982,906         Net income for the year                                       323,606       323,606         Net change in accumulated other comprehensive income   (net of deferred income tax expense of $10,940)                           14,964                   14,964         Capital contribution from Parent               10,521                               10,521         Capital issuance costs               (3,605   )                           (3,605   )     BALANCE, December 31, 2003       15,000       819,918           158,224           1,335,250       2,328,392         Net income for the year                                       367,288       367,288         Net change in accumulated other comprehensive income   (net of deferred income tax expense of $6,218)                           12,396                   12,396         Dividends paid                                       (30,000   )   (30,000   )     Capital contribution from Parent               20,419                               20,419         Capital issuance costs               (1,260   )                           (1,260   )     BALANCE, December 31, 2004       15,000       839,077           170,620           1,672,538       2,697,235         Net income for the year                                       351,978       351,978         Net change in accumulated other comprehensive income   (net of deferred income tax (benefit) of $(29,859))                           (62,538   )               (62,538   )     Dividends paid                                       (87,000   )   (87,000   )     Capital contributions               4,094                               4,094         Capital issuance costs               (1,343   )                           (1,343   )     BALANCE,   December 31, 2005       $   15,000       $   841,828           $   108,082           $   1,937,516       $   2,902,426         The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 4      FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)             Years Ended December 31,                 2005       2004       2003         Cash flows from   operating activities:                                 Premiums received, net       $   621,877       $   588,341       $   599,000         Policy   acquisition and other operating expenses paid, net       (165,833   )   (134,067   )   (99,321   )     Recoverable   advances recovered (paid)       (362   )   7,327       (959   )     Losses and loss   adjustment expenses paid       (1,124   )   (42,936   )   (5,972   )     Net investment   income received       200,623       170,958       143,615         Variable interest   entities’ net investment income received       40,599       30,189       13,964         Variable interest   entities’ interest paid       (6,739   )   (3,216   )   (3,585   )     Variable interest   entities’ net derivative payments       (25,655   )   (18,986   )   (8,808   )     Federal income   taxes paid       (114,066   )   (61,863   )   (77,815   )     Interest paid       (33,748   )   (32,765   )   (29,380   )     Income received   from refinanced assets       37,359       28,485       25,617         Other, net       (4,344   )   5,030       17,257         Net cash provided by   operating activities       548,587       536,497       573,613         Cash flows from   investing activities:                                 Proceeds from sales and   maturities of bonds (see   Note 3)       1,846,654       1,423,549       1,536,735         Purchases of bonds       (2,189,640   )   (1,882,243   )   (2,116,828   )     Purchases of property   and equipment       (32,354   )   (5,130   )   (477   )     Net decrease (increase)   in short-term investments       (17,687   )   (23,955   )   84,496         Purchases of variable   interest entities’ bonds       (309,674   )   (144,639   )   (146,239   )     Maturity of variable   interest entities’ bonds       292,150       213,825       —         Net decrease in variable   interest entities’ short-term investments       (1,479   )   9,908       13,048         Assets acquired in   refinancing transactions       —       (378,672   )   (53,625   )     Paydowns of assets   acquired in refinancing transactions       92,514       102,534       51,395         Proceeds from sales of   assets acquired in refinancing transactions       182,701       60,953       —         Other investments       2,127       14,305       4,643         Net cash used in   investing activities       (134,688   )   (609,565   )   (626,852   )     Cash flows from   financing activities:                                 Distribution to minority   shareholder       (55,443   )   (6,980   )   (3,290   )     Surplus notes repaid       —       (44,000   )   (60,000   )     Proceeds from issuance   of variable interest entities’ debt       206,674       102,139       101,189         Issuance of notes   payable       —       378,672       53,625         Repayment of notes   payable       (287,186   )   (130,157   )   (50,600   )     Capital issuance costs       (1,343   )   (1,260   )   (3,605   )     Dividends paid       (87,000   )   (30,000   )   —         Repayment of variable   interest entities’ preferred stock       —       (6,300   )   —         Repayment of variable   interest entities’ debt       (189,230   )   (190,681   )   —         Net cash (used in)   provided by financing activities       (413,528   )   71,433       37,319         Net increase (decrease)   in cash       371       (1,635   )   (15,920   )     Cash at beginning of   year       10,005       11,640       27,560         Cash at end of year       $   10,376       $   10,005       $   11,640         The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 5     FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (in thousands)             Years Ended December 31,                 2005       2004       2003         Reconciliation of net   income to net cash flows from operating activities:                                 Net income       $   351,978       $   367,288       $   323,606         Increase in accrued investment income       (2,471   )   (4,281   )   (9,904   )     Increase in deferred premium revenue net of prepaid   reinsurance premiums       173,351       192,464       259,072         Increase in deferred acquisition costs       (27,114   )   (34,369   )   (19,869   )     (Decrease) Increase in current federal income taxes   payable       13,581       (3,113   )   12,756         Increase (decrease) in unpaid losses and loss   adjustment expenses       24,857       (29,651   )   28,736         Decrease in amounts withheld for others       —       —       (18   )     Provision (benefit) for deferred income taxes       14,412       60,929       21,630         Net realized (gains) losses on investments       (11,685   )   970       (5,195   )     Depreciation and accretion of discount       7,905       9,550       3,899         Minority interest and equity in earnings of   unconsolidated subsidiaries       12,980       116,636       33,076         Change in other assets and liabilities       (9,207   )   (139,926   )   (74,176   )     Cash provided by   operating activities       $   548,587       $   536,497       $   573,613           On July 1, 2003, the Company consolidated $2.9 billion in assets and $2.9 billion in liabilities relating to variable interest entities with no corresponding cash movement. In 2005, 2004 and 2003, the Company received a tax benefit of $4.1 million, $20.4 million and $10.5 million, respectively, by utilizing its Parent’s losses. These amounts were recorded as a capital contribution. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. 6     FINANCIAL SECURITY ASSURANCE INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003 1.   ORGANIZATION AND OWNERSHIP Financial Security Assurance Inc. (“FSA” or, with its consolidated entities, the “Company”), a wholly owned subsidiary of Financial Security Assurance Holdings Ltd. (the “Parent”), is a New York insurance company. The Company is engaged in providing financial guaranty insurance on municipal and asset-backed obligations. The Company’s underwriting policy is to insure municipal and asset-backed obligations that it determines would be of investment-grade quality without the benefit of the Company’s insurance. The municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers’ taxing powers and of special revenue bonds and other special obligations of states and local governments that are supported by the issuers’ abilities to impose and collect fees and charges for public services or specific projects. Municipal obligations include obligations backed by the cash flow from leases or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities. The asset-backed obligations insured by the Company are generally issued in structured transactions and are backed by pools of assets, such as residential mortgage loans, consumer receivables, securities or other assets having an ascertainable cash flow or market value. The Company also insures synthetic asset-backed obligations that generally take the form of credit default swap (“CDS”) obligations or credit-linked notes that reference pools of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. Financial guaranty insurance written by the Company guarantees scheduled payments on an issuer’s obligation. In the case of a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or, at its option, to pay such amounts on an accelerated basis. In addition, the Company insures guaranteed investment contracts (“GICs”) issued by FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”), affiliates of the Company. The Company expects to continue to emphasize a diversified insured portfolio characterized by insurance of both municipal and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company’s insured portfolio consists primarily of municipal and asset-backed obligations originated in the United States of America, but the Company has also written and continues to pursue business in Europe and the Asia Pacific region. The Company consolidates the results of certain variable interest entities (“VIEs”), including FSA Global Funding Limited (“FSA Global”), Premier International Funding Co. (“Premier”) and Canadian Global Funding Corporation (“Canadian Global”). The Company consolidated FSA Global and Canadian Global beginning in the third quarter of 2003 in accordance with Financial Accounting Standards Board Interpretation No. 46, “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (“FIN 46”). The Company also began to consolidate Premier in the third quarter of 2003 as a result of obtaining control rights. The Company refinanced certain defaulted transactions by employing refinancing vehicles to raise funds for the refinancings. These refinancing vehicles are also consolidated. FSA Global is a special purpose funding vehicle owned 29% by an affiliate of the Company. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. The majority of Canadian Global’s assets were liquidated and its liabilities satisfied during the third quarter of 2004. Premier is principally engaged in debt defeasance for lease transactions. 7    The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. Substantially all of FSA Global’s assets are pledged as collateral to secure the repayment, on a pro rata basis, of FSA Global’s debt. On July 5, 2000, the Parent completed a merger in which the Parent became a direct subsidiary of Dexia Holdings, Inc. (“Dexia Holdings”) which, in turn, is owned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”), a Belgiun corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. 2.   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which differ in certain material respects from the accounting practices prescribed or permitted by insurance regulatory authorities (see Note 5). 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 in the Company’s consolidated balance sheets at December 31, 2005 and 2004, the reported amounts of revenues and expenses in the statements of operations and comprehensive income during the years ended December 31, 2005, 2004 and 2003 and disclosure of contingent assets and liabilities. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses, fair value of financial instruments and the deferral and amortization of policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows: Basis of Presentation The Consolidated Financial Statements include the accounts of the Company and its direct and indirect subsidiaries, principally including FSA Insurance Company, Financial Security Assurance International Ltd. (“FSA International”), and Financial Security Assurance (U.K.) Limited (collectively, the “Subsidiaries”). The Consolidated Financial Statements also include the accounts of certain VIEs as described in Note 1. All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the current year presentation. Investments Investments in debt and equity securities designated as available for sale are carried at fair value. The unrealized gain or loss on investments that are not hedged or are economically hedged but do not qualify for hedge accounting is reflected as a separate component of shareholders’ equity, net of applicable deferred income taxes. The unrealized gain or loss attributable to the hedged risk on investments that qualify as fair-value hedges is recorded in income currently. Bond discounts and premiums are amortized on the effective yield method over the remaining terms of the securities acquired. For mortgage-backed securities and any other holdings for which prepayment risk may be significant, assumptions regarding prepayments are evaluated periodically and revised as necessary. Any adjustments required due to the resulting change in effective yields are recognized in current income. Short-term investments, which are those investments with a maturity of less than one year at time of purchase, are carried at cost, which approximates fair value. Cash equivalents are amounts deposited in money market funds and investments with a maturity at time of purchase of three months or less and are included in short-term investments. Mortgage loans are carried at the lower of cost or market on an aggregate basis. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. Other-than-temporary impairments are reflected in earnings as a realized loss. 8    Investments in unconsolidated affiliates were based on the equity method of accounting (see Note 16). The Company records its share of unrealized gains or losses of the unconsolidated affiliates, net of applicable deferred taxes, in other comprehensive income. Derivatives The Company enters into derivative contracts to manage interest rate and foreign currency exposure of the VIE debt and VIE bond portfolio. The derivatives are recorded at fair value. These derivatives generally include interest-rate and currency swap agreements, which are primarily utilized to convert the Company’s fixed-rate obligations and investments on its VIE debt and VIE bond portfolio into U.S. dollar floating-rate obligations. The gains and losses relating to the fair-value of derivatives are included in net realized and unrealized gains (losses) on derivative instruments in the consolidated statements of operations and comprehensive income. The gains and losses related to derivatives designated as fair-value hedges are included in net interest income from variable interest entities and net interest expense from variable interest entities, as appropriate, along with the offsetting change in the fair value of the risk being hedged. The Company has also insured a number of CDS agreements that it intends, in each case, to hold for the full term of the agreement. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. Changes in fair value are recorded in net realized and unrealized gains (losses) on derivative instruments and in other assets or other liabilities, as appropriate. The Company uses quoted market prices, when available, to determine fair value. If quoted prices are not available, management uses internally developed estimates of fair value. Due to a lack of a quoted market for the CDS obligations written by the Company, estimates generated from the Company’s valuation process may differ materially from values that may be realized in market transactions. Premium Revenue Recognition Gross and ceded premiums received in upfront payouts are earned in proportion to the expiration of the related risk. For upfront premium transactions, premium earnings are greater in the earlier periods when there is a higher amount of exposure outstanding. The amount of risk outstanding is equal to the sum of the par amount of debt insured over the expected period of coverage. Deferred premium revenue and prepaid reinsurance premiums represent the portion of gross and ceded premium, respectively, that is applicable to coverage of risk to be provided in the future on policies in force. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred premium revenue and prepaid reinsurance premium, less any amount credited to a refunding issue insured by the Company, are recognized. For premiums received on an installment basis, the Company earns the premium over each installment period, typically less than one year, throughout the period of coverage. Typically, installment premiums are applicable to insured transactions that involve CDS or special purpose vehicles (“SPVs”) structured to finance pools of assets such as auto loans or mortgage loans. Premiums on such transactions are typically paid in installments because premium is paid from the interest spread available to the SPV (i.e. the difference in interest rate between the yield on its assets and the yield on its liabilities). The nature of the assets financed can have uncertain debt service schedules due to prepayments. When the Company, through its ongoing credit review process, identifies transactions where premiums are paid on an  9    installment basis and certain default triggers have been breached, the Company ceases to earn premiums on such transactions. Losses and Loss Adjustment Expenses Background Financial guaranty insurance generally provides an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Upon a payment default on an insured obligation, the Company is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or, at its option, to pay such amounts on an accelerated basis. The financial guaranty industry has emerged over the past thirty-four years. Management believes that existing insurance accounting under Statement of Financial Accounting Standards No. 60, “Accounting and Reporting by Insurance Enterprises” (“SFAS 60”), does not specifically address financial guaranty insurance. Accordingly, the accounting for loss and loss adjustment expenses within the financial guaranty insurance industry has developed based on analogy to the most directly comparable elements of existing literature, including sections of SFAS 60, Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”) and Emerging Issues Task Force Issue 85-20, “Recognition of fees for guaranteeing a loan” (“EITF 85-20”). Company-specific policy The Company establishes loss liabilities based on its estimate of specific and non-specific losses. The Company also establishes liabilities for loss adjustment expenses (“LAE”), consisting of the estimated cost of settling claims, including legal and other fees and expenses associated with administering the claims process. The Company calculates a loss and LAE liability based upon identified risks inherent in its insured portfolio. If an individual policy risk has a probable loss as of the balance sheet date, a case reserve is established. For the remaining policy risks in the portfolio, a non-specific reserve is established to account for the inherent credit losses that can be statistically estimated. Case reserves for financial guaranty insurance companies differ from those of traditional property and casualty insurance companies. The primary difference is that traditional property and casualty case reserves include only claims that have been incurred and reported to the insurance company. In a traditional property and casualty company, claims are incurred when defined events occur such as an auto accident, home fire or storm. Unlike traditional property and casualty claims, financial guaranty losses arise from the extension of credit protection and occur as the result of the credit deterioration of the issuer of the insured obligations over the lives of those insured obligations. Such deterioration and ultimate loss amounts can be projected based on historical experience in order to estimate probable loss, if any. Accordingly, specific loss events that require case reserves include (1) policies under which claim payments have been made and additional claim payments are expected, and (2) policies under which claim payments are probable and reasonably estimable, but have not yet been made. The Company establishes a case reserve for the present value of the estimated loss, net of subrogation recoveries, when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and reasonably estimable at the balance sheet date. When an insured obligation has met the criteria for establishing a case reserve and that transaction pays a premium in installments, those premiums, if expected to be received prospectively, are considered a form of recovery and are no longer earned as premium revenue. A case reserve is determined using cash flow or similar models that represent the Company’s estimate of the net present value of the anticipated shortfall between (1) scheduled  10    payments on the insured obligation plus anticipated loss adjustment expenses and (2) anticipated cash flow from and proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. The estimated loss, net of recovery, on a transaction is discounted using the risk-free rate appropriate for the term of the insured obligation at the time the reserve is established and is not subsequently adjusted. The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. The non-specific and case reserves, together represent the Company’s estimate of total reserves. Generally, when an insured credit deteriorates to a point where claims are expected, a case reserve is established. The establishment of a non-specific reserve for credits that have not yet defaulted is a common practice in the financial guaranty industry, although there are differences in the specific methodologies applied by other financial guarantors in establishing and measuring these reserves. The Company establishes a non-specific reserve on its portfolio of credits because management believes that a portfolio of insured obligations will deteriorate over its life and that the existence of inherent loss can be proven statistically by data such as rating agency publications. The establishment of the reserve is a systematic process that considers this quantitative, statistical information obtained primarily from Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Ratings Services (“S&P”), together with qualitative factors such as overall credit quality trends resulting from economic and political conditions, recent loss experience in particular segments of the portfolio and changes in underwriting policies and procedures. The factors used to establish reserves are evaluated periodically by comparing the statistically computed loss amount with the incurred losses as represented by case reserve activity to develop an experience factor, that is updated and applied to current-year originations. The process results in management’s best estimate of inherent losses associated with providing credit protection at each balance sheet date. The non-specific reserve established considers all levels of protection (e.g., reinsurance and overcollateralization). Net par outstanding for policies originated in the current period is multiplied by loss frequency and severity factors, with the resulting amounts discounted at the risk-free rates using the treasury yield curve (the “statistical calculation”). The discount rate does not change and is used to accrete the loss for the life of each policy. The loss factors used for the calculation are the product of default frequency rates obtained from Moody’s and severity factors obtained from S&P. Moody’s is chosen for default frequency rates due to its credibility, large population, statistical format and reliability of future update. The Moody’s default information is applied to all credit sectors or asset classes as described below. In its publication of default rates from 1970-2004, Moody’s tracks bonds over a twenty year horizon by credit rating at time of issuance. For the purpose of establishing appropriate severity factors, the Company’s methodology segregates the portfolio into asset classes, including health care transactions, all other municipal transactions, pooled corporate transactions, commercial real estate, and all other asset-backed transactions. The severity factors are derived from capital charge assessments provided by S&P. S&P capital charges project loss levels by asset class and are incorporated into their capital adequacy stress scenario analysis. The product of the current-year statistical calculation multiplied by the current-year experience factor represents the present value of loss amounts calculated for current-year originations. The experience factor is based on the Company’s inception-to-date historical losses (starting from 1993, when the Company established the non-specific reserve methodology). The experience factor is calculated by dividing cumulative inception-to-date actual losses incurred by the Company by the cumulative inception-to-date losses determined by the statistical calculation. The experience factor that applies to the whole portfolio is reviewed, and, where appropriate, updated periodically, but no less than annually. The present value of loss amounts calculated for the current-year originations is established at inception of the policy and there is no subsequent change unless significant adverse or favorable loss  11    experience is observed. In the event that the experience factor is either increased or decreased based on adverse or favorable loss experience, an analysis is performed of the non-specific reserve balance with particular emphasis on the asset class, if any, driving the experience factor adjustment. The objective of such analysis is to quantify the appropriate adjustment to the overall non-specific reserve balance for the change in experience. The adjustment that increases or decreases the non-specific reserve is charged or credited to loss expense. The present value of loss amounts calculated for the current-year originations plus an amount representing the accretion of discount pertaining to prior-year originations are charged to loss expense and increase the non-specific loss reserve after adjustments that may be made to reflect observed favorable or adverse experience. The entire non-specific reserve is available to absorb probable losses inherent in the portfolio. As there are no specific losses provided in the non-specific reserve, there is no identifiable reinsurance recoverable. At the time that a case reserve is identified, the gross loss liability is recognized along with the reinsurance recoverable, if any. The amount of reinsurance recoverable depends on the policy ceded and the reinsurance agreements covering such policy. Management cannot predict the specific policies that will emerge as case-basis losses from the portfolio and is not entitled to recovery from the reinsurer in advance of producing a case reserve. Since the non-specific reserve contains the inherent losses of the portfolio, when a case reserve adjustment is deemed appropriate, whether the result of adverse or positive credit developments, accretion or the addition of a new case reserve, a full transfer is made between the non-specific reserve and the case reserve balances with no effect to income. The adequacy of the non-specific reserve balance is reviewed periodically and at least annually based on a review of the Company’s inception-to-date cumulative losses divided by the total inception-to-date cumulative net par underwritten. This inception-to-date result is compared with the product of the non-specific reserves divided by the net par outstanding as of the balance sheet date. In the event that such ratios are not in line, then further analysis is performed to quantify appropriate adjustments that may be either charges or benefits on the statements of operations and comprehensive income, as occurred in 2003, 2004 and 2005. The table below presents the significant assumptions inherent in the calculations of the case and non-specific reserves.             As of December 31,                 2005       2004         Case reserve   discount rate       3.13%-5.90%       3.13%-5.90%         Non-specific   reserve discount rate       1.20%-7.95%       1.20%-7.95%         Current experience   factor       1.8       2.0           Reserving Methodology Industry Practice Management is aware that there are differences regarding the method of defining and measuring both case reserves and non-specific reserves among participants in the financial guaranty industry. Other financial guarantors may establish case reserves only after a default and use different techniques to estimate probable loss. Other financial guarantors may establish the equivalent of non-specific reserves, but refer to these reserves by various terms such as, but not limited to, “unallocated losses,” “active credit reserves” and “portfolio reserves,” or may use different statistical techniques from those the Company uses to determine loss at a given point in time. Management believes that existing accounting literature does not address the unique attributes of financial guaranty insurance. As an insurance enterprise, the Company initially refers to the accounting and financial reporting guidance in SFAS 60. In establishing loss liabilities, the Company relies principally on SFAS 60, which prescribes differing treatment depending on whether a contract is a short-duration contract or a long-duration contract. Financial guaranty insurance does not fall clearly within the definition  12    of either short-duration or long-duration contracts. Therefore, the Company does not believe that SFAS 60 alone provides sufficient guidance for financial guaranty claim liability recognition. As a result, the Company also analogizes to SFAS 5, which requires the establishment of liabilities when a loss is both probable and reasonably estimable. The Company also relies by analogy on EITF 85-20, which provides general guidance on the recognition of losses related to guaranteeing a loan. In the absence of a comprehensive accounting model provided by SFAS 60, industry participants, including the Company, have looked to such other guidance referred to above to develop their accounting policies for the establishment and measurement of loss liabilities. The Company believes that its financial guaranty loss reserve policy is appropriate under the applicable accounting literature, and that it best reflects the fact that a portfolio of credit-based insurance, comprising irrevocable contracts that cannot be unilaterally changed by the insurer and that match the maturity terms of the underlying insured obligation, contains probable and reasonably estimable losses. In January and February of 2005, the Securities and Exchange Commission (“SEC”) staff discussed with financial guaranty industry participants, differences in loss recognition practices among those participants. Based on discussions with the SEC staff, the Company understands that the Financial Accounting Standards Board (“FASB”) staff is considering additional guidance regarding financial guaranty insurance. When and if the FASB or SEC reach a conclusion on this issue, the Company and the rest of the financial guaranty industry may be required to change some aspects of their loss reserving policies, and the potential changes could extend to premium and expense recognition. The Company cannot predict how the FASB or SEC will resolve this issue and the resulting impact on its financial statements. Until additional guidance is issued, the Company intends to continue applying its existing policy regarding the establishment of both case and non-specific loss reserves. Deferred Acquisition Costs Deferred acquisition costs are comprised of expenses related to the production of business, including commissions paid on reinsurance assumed, compensation and related costs of underwriting and marketing personnel, certain rating agency fees, premium taxes and certain other underwriting expenses, reduced by ceding commission received on premiums ceded to reinsurers. Deferred acquisition costs are amortized over the period in which the related premiums are earned. When an insured issue is retired or defeased prior to the end of the expected period of coverage, the remaining deferred acquisition cost is recognized. A premium deficiency would be recognized if the present value of anticipated losses and loss adjustment expenses exceeded the sum of deferred premium revenue and estimated installment premiums. VIE Debt VIE debt is recorded at amortized cost. The Company may enter into associated transactions in order to reduce the Company’s exposure to fluctuations in interest and foreign currency rates and its related effect on the fair value of the debt. The change in the fair value of the hedged item in a qualifying accounting hedge attributable to the hedged risk adjusts the carrying amount of the hedged item and is recognized in income currently. VIE debt may include hybrid debt instruments that contain embedded derivatives. Under certain conditions, embedded derivatives are required to be separated from the debt instrument and accounted for at fair value, with all changes reflected through earnings. Foreign Currency Translation Monetary assets and liabilities denominated in foreign currencies are translated at the spot rate at the balance sheet date. Non-monetary assets and liabilities are translated at historical rates. Revenues and expenses denominated in foreign currencies are translated at average rates prevailing during the year.  13    Unrealized gains and losses on available-for-sale securities, net of deferred taxes, resulting from translating investments denominated in foreign currencies are recorded in shareholders’ equity. Gains and losses from transactions in foreign currencies are recorded in income. Federal Income Taxes The provision for income taxes consists of an amount for taxes currently payable and a provision for the deferred tax consequences of temporary differences between the tax basis of assets and liabilities and the financial statement basis. Non-interest-bearing tax and loss bonds are purchased to prepay 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 other assets. Assets Acquired in Refinancing Transactions Asset-backed senior notes represent the Company’s purchase of less than 50% of a refinanced transaction. Asset-backed senior notes are carried at cost, with any reduction in carrying value recognized as an adjustment to yield. 3.   INVESTMENTS Bonds and short-term deposits at amortized cost of $9.9 million and $9.7 million at December 31, 2005 and 2004, respectively, were on deposit with state regulatory authorities as required by insurance regulations. Consolidated net investment income, excluding income attributable to the variable interest entities’ bond and short term portfolio (the “VIE portfolio”), consisted of the following (in thousands):             Years Ended December 31,                 2005       2004       2003         Bonds and   short-term investments       $   193,347       $   173,849       $   155,963         Equity   investments       8,931       —       —         Investment   expenses       (3,051   )   (2,907   )   (2,892   )     Net investment income       $   199,227       $   170,942       $   153,071           The credit quality of bonds, excluding the VIE portfolio, at December 31, 2005 was as follows:     Rating(1)               Percent of   Bonds         AAA           78.4   %         AA           17.6             A            4.0                         100.0   %            (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. Of the bonds included in the investment portfolio, excluding the VIE portfolio, 6.9% were Triple-A by virtue of insurance provided by FSA (“FSA-Insured Investments”). Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating, which is the rating without giving effect to the FSA guaranty, of the FSA-Insured Investments was the Double-A range.   14     The amortized cost and fair value of the investment portfolio, excluding the VIE portfolio, were as follows (in thousands):     December 31, 2005               Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         U.S. Treasury   securities and obligations of                                                         U.S. government   corporations and agencies       $   189,368           $   3,554               $   (748   )       $   192,174         Obligations of states and political subdivisions       3,431,046           173,279               (5,457   )       3,598,868         Foreign       116,217           1,260               (5,191   )       112,286         Mortgage-backed securities       245,783           807               (4,487   )       242,103         Corporate securities       185,381           1,797               (2,114   )       185,064         Asset-backed securities       40,216           10               (252   )       39,974         Subtotal       4,208,011           180,707               (18,249   )       4,370,469         Short-term investments       133,283           —               —           133,283         Total       $   4,341,294           $   180,707               $   (18,249   )       $   4,503,752               December 31, 2004               Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         U.S. Treasury   securities and obligations of                                                         U.S. government   corporations and agencies       $   143,915           $   4,984               $   (347   )       $   148,552         Obligations of states and political subdivisions       3,058,967           220,875               (1,987   )       3,277,855         Foreign       126,099           19,895               (714   )       145,280         Mortgage-backed securities       219,834           3,619               (1,322   )       222,131         Corporate securities       232,457           7,056               (504   )       239,009         Asset-backed securities       56,843           312               (71   )       57,084         Subtotal       3,838,115           256,741               (4,945   )       4,089,911         Short-term investments       115,596           —               —           115,596         Total       $   3,953,711           $   256,741               $   (4,945   )       $   4,205,507           The following table shows the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities, excluding the VIE portfolio, have been in a continuous unrealized loss position, at December 31, 2005 (in thousands):             As of December 31, 2005                 Less than 12 months       12 months or more       Total                 Fair   Value       Unrealized   Losses       Fair   Value       Unrealized   Losses       Fair   Value       Unrealized   Losses         U.S. Treasury securities   and obligations of U.S. government corporations and agencies       $   65,026           $   (429   )       $   14,635           $   (319   )       $   79,661           $   (748   )         Obligations of states and   political subdivisions       375,766           (3,609   )       108,031           (1,848   )       483,797           (5,457   )         Mortgage-backed securities       137,833           (2,195   )       48,060           (2,292   )       185,893           (4,487   )         Corporate securities       102,576           (1,482   )       23,650           (632   )       126,226           (2,114   )         Foreign       37,480           (5,181   )       1,508           (10   )       38,988           (5,191   )         Asset-backed securities       18,540           (124   )       14,813           (128   )       33,353           (252   )         Total       $   737,221           $   (13,020   )       $   210,697           $   (5,229   )       $   947,918           $   (18,249   )           15                  As of December 31, 2004                 Less than 12 months       12 months or more       Total                 Fair   Value       Unrealized   Losses       Fair   Value       Unrealized   Losses       Fair   Value       Unrealized   Losses         U.S. Treasury securities and obligations of U.S. government   corporations and agencies       $   50,812           $   (183   )       $   4,189           $   (164   )       $   55,001           $   (347   )         Obligations of states and political subdivisions       214,194           (1,266   )       67,095           (721   )       281,289           (1,987   )         Mortgage-backed   securities       32,701           (304   )       38,784           (1,018   )       71,485           (1,322   )         Corporate   securities       26,725           (161   )       17,859           (343   )       44,584           (504   )         Foreign       1,722           (39   )       40,136           (675   )       41,858           (714   )         Asset-backed   securities       16,279           (71   )       —           —           16,279           (71   )         Total       $   342,433           $   (2,024   )       $   168,063           $   (2,921   )       $   510,496           $   (4,945   )           The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether any investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were 96 securities that were in an unrealized loss position for a continuous 12-month period or longer. None of the 96 securities had an unrealized loss that exceeded book value by 11% at December 31, 2005. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired. The amortized cost and fair value of bonds in the investment portfolio, excluding the VIE portfolio, at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized   Cost       Fair Value         Due in one year or less       $   225,593       $   225,655         Due after one year   through five years       1,187,634       1,247,746         Due after five years   through ten years       670,695       701,085         Due after ten years       1,971,373       2,047,189         Mortgage-backed   securities (stated maturities of 1 to 30 years)       245,783       242,103         Asset-backed securities   (stated maturities of 2 to 29 years)       40,216       39,974         Total       $   4,341,294       $   4,503,752           Proceeds from sales of bonds for the investment portfolio, excluding the VIE portfolio, during 2005, 2004 and 2003 were $1,717.0 million, $1,155.7 million and $1,093.9 million, respectively. Proceeds from maturities of bonds for the investment portfolio during 2005, 2004 and 2003 were $129.7 million, $267.8 million and $442.8 million, respectively. Gross gains of $10.8 million, $4.5 million and $11.5 million and gross losses of $5.6 million, $5.5 million and $6.3 million were realized on sales in 2005, 2004 and 2003, respectively. 4.   DEFERRED ACQUISITION COSTS Acquisition costs deferred for amortization against future income and the related amortization charged to expenses are as follows (in thousands):             Years Ended December 31,                 2005       2004       2003         Balance, beginning of   period       $   308,015       $   273,646       $   253,777         Costs deferred during   the period:                                 Ceding commission   income, net       (63,174   )   (65,838   )   (73,943   )     Premium taxes       20,894       16,551       16,773         Compensation and other   acquisition costs       137,734       145,857       135,430         Total       95,454       96,570       78,260         Costs amortized during   the period       (68,340   )   (62,201   )   (58,391   )     Balance, end of period       $   335,129       $   308,015       $   273,646           16     5.   STATUTORY ACCOUNTING PRACTICES GAAP differs in certain significant respects from statutory accounting practices applicable to the Company and its insurance company subsidiaries, that are prescribed or permitted by insurance authorities. The principal differences result from the following statutory accounting practices: ·        upfront premiums are recognized as earned when related principal and interest have expired rather than over the expected coverage period; ·        acquisition costs are charged to operations as incurred rather than as related premiums are earned; ·        a contingency reserve (rather than a non-specific reserve) is computed based on the following statutory requirements: 1)               For all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions plus 2)               For all policies written on or after July 1, 1989, an amount equal to the greater of 50% of premiums written for each category of insured obligation or a designated percentage of principal guaranteed for that category. These amounts are provided each quarter as either  1¤60th or  1¤80th of the total required for each category, less permitted reductions; ·        certain assets designated as “non-admitted assets” are charged directly to statutory surplus but are reflected as assets under GAAP; ·        deferred tax assets are generally admitted to the extent reversals of existing temporary differences in the subsequent year can be recovered through carry back; ·        insured CDS are considered to be insurance contracts, not derivative contracts recorded at fair value; ·        bonds are carried at amortized cost; ·        VIEs and refinancing vehicles are not consolidated under statutory accounting standards; and ·        surplus notes are recognized as surplus rather than as a liability unless approved for repayment Reconciliations of net income for the years ended 2005, 2004 and 2003 and shareholders’ equity at December 31, 2005 and 2004, reported by the Company on a GAAP basis, to the amounts reported by the insurance company subsidiaries on a statutory basis, are as follows (in thousands):             Year Ended December 31,         Net Income:               2005       2004       2003         FSA consolidated GAAP net income       $   351,978       $   367,288       $   323,606         Deferral of net acquisition costs       (95,454   )   (96,571   )   (78,259   )     Amortization of acquisition costs       68,340       62,202       58,391         Fair-value adjustment on derivatives       (9,836   )   (54,182   )   (35,091   )     Loss expense       17,276       3,889       21,813         Consolidation of assets acquired in refinancing   transactions       (10,207   )   (6,771   )   (335   )     Deferred income tax       17,335       63,465       11,364         Current income tax       (2,416   )   (18,706   )   (18,048   )     Earned premium       (44,388   )   (74,707   )   (25,178   )     Other       342       (3,826   )   4,681         FSA consolidated   statutory net income       $   292,970       $   242,081       $   262,944                          17                  As of December 31,         Shareholders’ Equity:               2005       2004         FSA consolidated GAAP Equity       $   2,902,426       $   2,697,235         Deferred acquisition costs       (335,129   )   (308,015   )     Fair-value of derivatives       (56,811   )   (47,343   )     Loss reserves       115,162       96,381         Contingency reserves       (906,841   )   (1,099,462   )     Unrealized gain on investments       (174,878   )   (240,895   )     Consolidation of assets acquired in refinancing   transactions       248       (1,960   )     Surplus notes       93,850       74,299         Deferred income taxes       263,206       275,323         Deferred premium revenue       (335,037   )   (307,173   )     Other       (55,521   )   43,031         FSA statutory surplus       1,510,675       1,181,421         Statutory surplus   plus contingency reserve       $   2,417,516       $   2,280,883                       6.   FEDERAL INCOME TAXES Dexia Holdings, the Parent and the Company and its Subsidiaries, except FSA International, file a consolidated federal income tax return. A tax-sharing agreement between them provides that each member’s tax benefit or expense is calculated on a separate return basis and that any credits or losses available to the Parent or Dexia Holdings be allocated among the members based on each member’s taxable income. At December 31, 2005 and 2004, the Company and its Subsidiaries received benefits from utilizing the Parent’s credits and losses of $4.1 million and $20.4 million, respectively. These amounts have been recorded as capital contributions and reductions in amounts payable to the Parent in the financial statements. Except as described below, federal income taxes were not provided on all of the undistributed earnings of FSA International, since it was the Company’s practice and intent to reinvest such earnings in the operations of this subsidiary. The cumulative amount of such untaxed earnings was $22.6 million and $86.7 million at December 31, 2004 and 2003, respectively. The American Jobs Creation Act of 2004 (the “Act”), enacted on October 22, 2004, added Section 965 to the Internal Revenue Code. Section 965 provides for the repatriation of dividends from a controlled foreign corporation to its U.S. shareholder at an effective tax rate of 5.25%, provided that proceeds from the repatriation are utilized for qualified domestic investment activities. The U.S. Treasury Department issued Notice 2005-10, which provided guidance on acceptable investment activities. The Company believes it qualifies for the beneficial treatment under Section 965 and accordingly accrued a tax liability and expense of $5.3 million at December 31, 2004. This amount approximated the tax effect on FSA International’s tax dividend distribution made in the fourth quarter of 2005. In December 2005, the Company repatriated earnings from FSA International to avail itself of the reduced effective tax rate of 5.25% (compared with the normal effective tax rate of 35%). In connection with such repatriation, the Company recapitalized FSA International in October of 2005 to become a wholly owned subsidiary and declared that it no longer intends to leave future earnings of that subsidiary permanently offshore. FSA International is subject to an increased effective U.S. tax rate on its 2005 and future income. The impact on earnings reflects (1) a tax liability of $15.1 million in respect of earnings of FSA International that have previously been recognized for GAAP but not yet for tax and (2) $14.2 million related to 2005 earnings. 18     The cumulative balance sheet effects of deferred federal tax consequences are as follows (in thousands):             December 31,                 2005       2004         Deferred   acquisition costs       $   104,335       $   95,736         Deferred premium   revenue adjustments       36,302       37,826         Unrealized capital   gains       58,204       88,902         Contingency   reserves       114,166       113,507         Undistributed   earnings       16,613       —         Derivative   fair-value adjustments       86,743       137,949         Other       3,817       7,655         Total deferred federal income tax liabilities       420,180       481,575         Loss and loss   adjustment expense reserves       (41,533   )   (35,540   )     Deferred   compensation       (67,277   )   (67,944   )     Foreign currency   transaction loss       (12,300   )   (69,139   )     Minority interest       (56,437   )   (54,424   )     Other       (4,291   )   (756   )     Total deferred federal income tax assets       (181,838   )   (227,803   )     Net deferred federal   income tax liability       $   238,342       $   253,772           Management believes it is more likely than not that the tax benefit of the deferred tax assets will be realized. Accordingly, no valuation allowance was necessary at December 31, 2005 or 2004. A reconciliation of the effective tax rate with the federal statutory rate follows:             Years Ended   December 31,                 2005       2004       2003         Tax at statutory   rate       35.0   %   35.0   %   35.0   %     Tax-exempt   investments       (9.0   )   (8.3   )   (8.5   )     Income of foreign   subsidiary       2.5       (1.3   )   (2.5   )     Minority interest       (0.4   )   —       —         Other       0.1       (0.2   )   0.3         Provision for income   taxes       28.2   %   25.2   %   24.3   %       7.   DIVIDENDS AND CAPITAL REQUIREMENTS FSA’s ability to pay dividends depends on FSA’s financial condition, results of operations, cash requirements, rating agency capital adequacy and other related factors, and is also subject to restrictions contained in the insurance laws and related regulations of New York and other states. Under the insurance laws of the State of New York, FSA may pay dividends out of earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of (a) 10% of policyholders’ surplus as of its last statement filed with the Superintendent of Insurance of the State of New York (the “New York Superintendent”) or (b) adjusted net investment income during this period. FSA paid $87.0 million of dividends in 2005 and $30.0 million in 2004. Based upon FSA’s statutory statements for December 31, 2005, the maximum amount normally available for payment of dividends by FSA without regulatory approval over the following 12 months would be approximately $153.8 million. 19    8.   CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES FSA has a credit arrangement aggregating $150.0 million, that is provided by commercial banks and intended for general application to insured transactions. If FSA is downgraded below Aa3 and AA-, the lenders may terminate the commitment and the commitment commission becomes due and payable. If FSA is downgraded below Baa3 and BBB-, any outstanding loans become due and payable. At December 31, 2005, there were no borrowings under this arrangement, which expires on April 21, 2006, if not extended. FSA has a standby line of credit commitment in the amount of $350.0 million with a group of international banks to provide loans to FSA after it has incurred, during the term of the facility, cumulative municipal losses (net of any recoveries) in excess of the greater of $350.0 million or the average annual debt service of the covered portfolio multiplied by 5.00%, which amounted to $1,220.0 million at December 31, 2005. The obligation to repay loans made under this agreement is a limited recourse obligation payable solely from, and collateralized by, a pledge of recoveries realized on defaulted insured obligations in the covered portfolio, including certain installment premiums and other collateral. This commitment has a term expiring on April 30, 2015 and contains an annual renewal provision, commencing April 30, 2008, subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 2005. In June 2003, $200.0 million of money market committed preferred trust securities (the “CPS Securities”) were issued by trusts created for the primary purpose of issuing the CPS Securities, investing the proceeds in high-quality commercial paper and providing FSA with put options for issuing to the trusts non-cumulative redeemable perpetual preferred stock (the “Preferred Stock”) of FSA. If FSA 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 FSA in exchange for Preferred Stock of FSA. FSA pays a floating put premium to the trusts. The cost of the structure was $1.3 million and $1.3 million for 2005 and 2004 respectively, and was recorded in equity. The trusts are vehicles for providing FSA access to new capital at its sole discretion through the exercise of the put options. The Company does not consider itself to be the primary beneficiary of the trusts under FIN 46R because it does not retain the majority of the residual benefits or expected losses. The Company had borrowed $108.9 million from its Parent in the form of Surplus Notes. These notes carry a simple interest rate of 5.0% per annum. Principal and interest on the Surplus Notes may be paid at any time at the option of the Company, subject to prior approval of the New York Superintendent and compliance with the conditions to such payments as contained in the New York Insurance Laws. These notes have no stated maturity. The Company paid interest of $5.4 million, $6.7 million and $9.3 million in 2005, 2004 and 2003, respectively. In 2004 and 2003 respectively, with the approval of the New York Superintendent, FSA repaid $44.0 million and $60.0 million of principal on such notes. There were no repayments in 2005. 9.   EMPLOYEE BENEFIT PLANS The Company maintains both qualified and non-qualified non-contributory defined contribution pension plans for the benefit of eligible employees. Contributions are based on a fixed percentage of employee compensation. Pension expense, which is funded annually, amounted to $6.1 million, $5.2 million and $4.3 million for the years ended December 31, 2005, 2004 and 2003, respectively. The Company has an employee retirement savings plan for the benefit of eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by Internal Revenue Service Code, Section 401(k). Contributions by the Company are discretionary, and none have been made. Through 2004, performance shares were awarded under the Parent’s 1993 Equity Participation Plan (the “1993 Equity Plan”). The 1993 Equity Plan authorized the discretionary grant of performance shares  20    by the Human Resources Committee to key employees. The amount earned for each performance share depends on the attainment of certain growth rates of adjusted book value and book value per outstanding share over a three-year period. Performance shares issued prior to January 1, 2005 permitted the participant to elect, at the time of award, growth rates including or excluding realized and unrealized gains and losses on the Parent’s consolidated investment portfolio excluding invested assets in the VIE portfolio. Performance shares issued after January 1, 2005 do not offer the option to include the impact of unrealized gains and losses on the investment portfolio. No payout occurs if the compound annual growth rate of the Parent’s consolidated adjusted book value and book value per outstanding share over specified three-year performance cycles is less than 7%, and a 200% payout occurs if the compound annual growth rate is 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%. In 2004, the Company adopted the 2004 Equity Participation Plan (the “2004 Equity Plan”) which continues the incentive compensation program formerly provided under the Company’s 1993 Equity Participation Plan. The 2004 Equity Plan provides for performance share units comprised 90% of performance shares (which provide for payment based upon the Parent’s consolidated performance over specified three-year performance cycles as described above) and 10% of shares of Dexia restricted stock. The Dexia restricted share component is a fixed plan, where the Company purchases Dexia shares and establishes a prepaid expense for the amount paid which is amortized over 2.5 and 3.5 years vesting periods. In the first quarter of 2005, FSA purchased shares to economically defease its liability for $4.4 million. This amount is being amortized to expense over the employees’ vesting period. Performance shares granted under the 1993 Equity Plan and 2004 Equity Plan are as follows:             Outstanding   at Beginning   of Year       Granted   During   the Year       Paid out   During   the Year       Forfeited   During   the Year       Outstanding   at End   of Year       Price per   Share at   Grant Date         2003           1,415,826           342,845       464,778           13,261               1,280,632               $   92.72             2004           1,280,632           349,506       398,292           20,038               1,211,808               109.71             2005           1,211,808           330,957       313,987           24,434               1,204,344               131.30               The estimated the final cost of these performance shares is accrued over the performance period. The expense for the performance shares was $50.6 million, $67.0 million and $58.1 million, for the years ended December 31, 2005, 2004 and 2003, respectively. Awards of Dexia restricted stock remain restricted for an additional six months after the end of the vesting periods. In 2005, the Company awarded 194,202 Dexia restricted shares valued at $22.69 on the award date. As of December 31, 2005, 5,150 shares had been forfeited and 8,756 shares had vested. 10.   COMMITMENTS AND CONTINGENCIES Effective June 2004, the Company entered into a 21-year sublease agreement with Deutsche Bank AG for office space at 31 West 52nd Street, New York, New York to be used as the Company’s new headquarters. The Company moved to this new space in June 2005. The lease contains scheduled rent increases every five years after a 19-month rent-free period, as well as lease incentives for initial construction costs of up to $6.0 million, as defined in the sublease. The lease contains provisions for rent increases related to increases in the building’s operating expenses. The lease also contains a renewal option for an additional ten-year period, and an option to rent additional office space at various points in the future, in each case at then-current market rents. In addition the Company and its subsidiaries lease  21     additional office space under non-cancelable operating leases, which expire at various dates through 2013. Future minimum rental payments are as follows (in thousands): Future minimum rental payments are as follows (in thousands):     Year Ended   December 31,                         2006       $   7,141.6         2007       8,263.6         2008       8,217.3         2009       8,204.7         2010       8,141.2         Thereafter       119,848.4         Total       $   159,816.8           Rent expense was $9.2 million in 2005, $6.9 million in 2004 and $6.6 million in 2003. Rent expense in 2005 includes a $1.1 million lease termination fee related to the Company’s former headquarters. During the ordinary course of business, the Company and its subsidiaries have become parties to certain litigation. The Company is not subject to any material pending legal proceedings. 11.   REINSURANCE The Company obtains reinsurance to increase its policy-writing capacity on both an aggregate-risk and a single-risk basis; to meet rating agency, internal and state insurance regulatory limits; to diversify risk; to reduce the need for additional capital; and to strengthen financial ratios. The Company reinsures portions of its risks with affiliated (see Note 13) and unaffiliated reinsurers under quota share, first-loss and excess-of-loss treaties and on a facultative basis. In the event that any or all of the reinsuring companies are unable to meet their obligations, or contest such obligations, the Company would be unable to recover for such defaulted amounts. Certain of the reinsuring companies have provided collateral to secure their reinsurance obligations. Amounts of ceded and assumed business were as follows (in thousands):             Year Ended December 31,                 2005       2004       2003         Written premiums ceded       $   256,087       $   244,211       $   281,542         Written premiums assumed       9,474       11,567       3,294         Earned premiums ceded       150,087       161,733       159,350         Earned premiums assumed       3,521       6,608       3,832         Losses and loss   adjustment expense payments ceded       1,465       52,372       16,993         Losses and loss adjustment expense payments assumed       8       16       —                                    December 31,                 2005       2004         Principal outstanding   ceded       $   120,607,468       $   116,687,760         Principal outstanding   assumed       2,597,375       2,134,427         Deferred premium revenue   ceded       865,192       759,191         Deferred premium revenue   assumed       23,777       17,823         Losses and loss   adjustment expense reserves ceded       36,339       35,419         Losses and loss adjustment expense reserves assumed       643       553                     22    12.   OUTSTANDING EXPOSURE AND COLLATERAL The Company’s policies insure the scheduled payments of principal and interest on municipal and asset-backed (including insured FSA-insured CDS) obligations. The gross amount of financial guarantees in force (principal and interest) was $685.1 billion at December 31, 2005 and $631.3 billion at December 31, 2004. The net amount of financial guarantees in force was $497.1 billion at December 31, 2005 and $453.2 billion at December 31, 2004. The net par outstanding as of December 31, 2005 and 2004 and the contractual terms to maturity are as follows (in millions):           December 31, 2005       December 31, 2004         Terms to Maturity(1)               Asset-Backed(2)       Municipal       Asset-Backed(2)       Municipal         0 to 5 years           $   41,997           $   44,272           $   46,800           $   39,448         5 to 10 years           31,354           49,935           29,155           43,165         10 to 15 years           12,180           44,392           10,772           37,174         15 to 20 years           744           36,737           1,084           30,857         20 years and above           37,611           51,724           41,682           44,748         Total           $   123,886           $   227,060           $   129,493           $   195,392                                   (1)          Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. (2)          Includes related party insurance of $13,463 million and $7,143 million, in 2005 and 2004, respectively relating to FSA-insured GICs issued by the GIC Affiliates. The par amount ceded as of December 31, 2005 and 2004 and the terms to maturity are as follows (in millions):           December 31, 2005       December 31, 2004         Terms to Maturity               Asset-Backed       Municipal       Asset-Backed       Municipal         0 to 5 years           $   16,180               $   12,950               $   21,662               $   11,443             5 to 10 years           7,011               16,332               6,909               14,707             10 to 15 years           1,477               16,954               2,228               14,630             15 to 20 years           1,474               15,180               1,373               12,870             20 years and above           4,001               29,048               4,862               26,004             Total           $   30,143               $   90,464               $   37,034               $   79,654                                            The net par outstanding of insured obligations in the municipal insured portfolio includes the following amounts by type of issue (in millions):           Net Par Outstanding   as of December 31,       Ceded as of   December 31,         Types of Issues               2005       2004       2005       2004         General obligation bonds       $   91,338       $   77,865       $   26,295       $   24,278         Housing revenue bonds       7,585       7,628       2,153       2,224         Municipal utility   revenue bonds       36,794       33,544       13,999       13,761         Health care revenue   bonds       11,789       9,261       8,889       7,784         Tax-supported bonds   (non-general obligation)       40,622       36,631       16,776       14,564         Transportation revenue   bonds       14,695       12,834       8,944       7,584         Other municipal bonds       24,237       17,629       13,408       9,459         Total municipal obligations       $   227,060       $   195,392       $   90,464       $   79,654                             The Company limits its exposure to losses from writing financial guarantees by underwriting investment-grade obligations, diversifying its portfolio and maintaining rigorous collateral requirements on  23    asset-backed obligations, as well as through reinsurance. The net par outstanding of insured obligations in the asset-backed insured portfolio includes the following amounts by type of collateral (in millions):           Net Par Outstanding (1)   as of December 31,       Ceded as of   December 31,         Types of Collateral               2005       2004       2005       2004         Residential mortgages       $   24,718       $   35,641       $   3,841       $   4,997         Consumer receivables       9,835       9,540       1,593       2,241         Pooled corporate   obligations       66,873       68,340       20,688       26,223         Other asset-backed obligations       22,460       15,972       4,021       3,573         Total asset-backed obligations       $   123,886       $   129,493       $   30,143       $   37,034                               (1)          Includes related party insurance of $13,463 million and $7,143 million, in 2004 and 2003, respectively, relating to FSA-insured GICs issued by the GIC Affiliates. In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance covering securitizations of pools of such assets as residential mortgages or consumer receivables. However, after the initial issuance of an insurance policy relating to such securitizations, the geographic concentration of the underlying assets may not remain fixed over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not deemed by the Company to be significant, given other more relevant measures of diversification, such as issuer or industry diversification. The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The following table sets forth those states in which municipalities located therein issued an aggregate of 2% or more of the Company’s net par amount outstanding (in millions) of insured municipal securities as of December 31, 2005:     State               Number   of Issuers       Net Par   Amount   Outstanding       Percent of Total   Municipal Net   Par Amount   Outstanding       Ceded Par   Amount   Outstanding         California           985               $   30,159               13.3   %           $   10,467             New York           671               19,555               8.6               9,718             Texas           730               15,458               6.8               5,301             Pennsylvania           752               14,843               6.5               3,791             Florida           277               12,063               5.3               4,004             Illinois           653               11,255               5.0               5,411             New Jersey           584               10,459               4.6               5,644             Washington           328               8,289               3.6               3,192             Michigan           499               8,252               3.6               2,219             Massachusetts           206               6,309               2.8               3,325             Ohio           332               5,239               2.3               2,194             Wisconsin           437               4,938               2.2               1,297             Georgia           117               4,743               2.1               1,457             All other U.S.   jurisdictions           2,937               63,251               27.9               23,027             International           112               12,247               5.4               9,417             Total           9,620               $   227,060               100.0   %           $   90,464               13.   RELATED PARTY TRANSACTIONS Allocable expenses are shared by the Company and its Parent on a basis determined principally by estimates of respective usage as stated in an expense sharing agreement. The agreement is subject to the provisions of the New York Insurance Law. Amounts included in other assets at December 31, 2005 and 2004 are $5.3 million and $11.2 million respectively, for unsettled expense allocations due from the Parent. 24    For the years ended December 31, 2005, 2004, 2003, the Company ceded premiums of $31.6 million, $35.2 million and $48.8 million, respectively, to subsidiaries of XL Capital Ltd (“XL”), a major Bermuda-based insurance holding company, which owned an interest in FSA International prior to October 2005 when it redeemed its interest in exchange for $39.1 million. In 2005, 2004 and 2003, FSA International paid preferred dividends of $16.3 million, $7.0 million and $3.3 million, respectively, to XL. The amounts included in prepaid reinsurance premiums at December 31, 2005 and 2004 for reinsurance ceded to subsidiaries of XL were $84.4 million and $70.3 million, respectively. The amounts of reinsurance recoverable for unpaid losses at December 31, 2005 and 2004 for reinsurance ceded to subsidiaries of XL were $1.8 million and $8.2 million, respectively. The Company earned premiums of $2.5 million in the first half of 2003 relating to the guarantees of debt issued or assets purchased by FSA Global and Canadian Global. Inter-company premiums earned relating to VIEs have been eliminated in consolidation for periods subsequent to July 1, 2003. The VIE portfolio contains $1,142.1 million at December 31, 2005 and $961.9 million at December 31, 2004 of GICs issued by the GIC Affiliates. The Company recognized $38.4 million and $20.7 million in VIE net interest income during 2005 and 2004 respectively, related to these investments. The Company earned premiums of $28.0 million, $28.0 million and $20.5 million for the years ended December 31, 2005, 2004 and 2003, respectively, relating to business with affiliates of Dexia. Deferred premium revenue relating to those transactions was $19.5 million and $17.0 million at December 31, 2005 and 2004, respectively. Gross par outstanding relating to those transactions was $21.5 billion and $24.0 billion at December 31, 2005 and 2004, respectively. The Company also paid Dexia a fee of $0.7 million in 2003 relating to business in which both Dexia and the Company were involved. No payments were made in 2004 and 2005. For the years ended December 31, 2005 and 2004, the Company, via its interest in VIE holdings, recorded pre-tax income (loss) of $(16.4) million and $89.8 million relating to swaps where Dexia was the counterparty. The Company recorded other assets of $309.6 million at December 31, 2005 and $319.7 million at December 31, 2004, primarily relating to swaps where Dexia was the counterparty. In addition, at December 31, 2005 and 2004 the Company had $172.1 million and $163.0 million in VIE debt relating to debt issued to Dexia. During 2005 and 2004, the Company recorded $9.3 million and $8.8 million in VIE net interest expense relating to such debt. The Company had premiums earned of $27.0 million, $15.4 million and $7.5 million at December 31, 2005, 2004 and 2003, respectively, relating to the guaranty of GICs issued by the GIC Affiliates. 14.   DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The Company determines fair value using available market information and appropriate valuation methodologies. However, considerable judgment is necessary to interpret the data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amount the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair-value amounts. For bonds, equity securities and the VIE bond portfolio, the carrying amount represents fair value. The fair value is based on quoted market price or redemption value for the Company’s investment in XLFA. For short-term investments, including the VIE short-term investments, the carrying amount is cost, which approximates fair market value due to the short maturity of the instruments. For cash, receivable for investments sold and payable for investments purchased, the carrying amount is cost, which approximates fair value because of the short maturity of these instruments. For assets acquired under refinancing transactions, the fair value is either the present value of the expected cash flows or quoted market prices as of the reporting date. 25     For deferred premium revenue, net of prepaid reinsurance premiums, the carrying amount represents the Company’s future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance policy. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the statutory premiums that would be paid under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of that portion of the premiums retained by the Company to compensate it for originating and servicing the insurance contract. For notes payable to affiliate, the carrying amount of notes payable represents the principal amount due at maturity. The fair value is based on the quoted market price. For installment premiums, consistent with industry practice, there is no carrying amount since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to the treatment of deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues that would be received under a reinsurance agreement with a third party to transfer the Company’s financial guaranty risk, net of that portion of the premium retained by the Company to compensate it for originating and servicing the insurance contract. For VIE debt, the fair value is the present value of the expected cash flows as of the reporting date. For losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses, the carrying amount is net present value of the expected cash flows for specifically identified claims and inherent losses in the Company’s insured portfolio, which management believes is a reasonable proxy for fair value. For fair-value adjustments on derivatives, the carrying amount represents fair value. The Company uses quoted market prices when available, but if quoted market prices are not available, management uses internally developed estimates. The table below shows the carrying amount and fair value of the Company’s financial instruments (in thousands):             December 31, 2005       December 31, 2004                 Carrying   Amount       Fair Value       Carrying   Amount       Fair Value         Assets:                                         Bonds       $   4,370,469       $   4,370,469       $   4,089,911       $4,089,911         Equity securities       54,370       54,370       54,300       54,300         Variable interest   entities’ bonds       1,155,992       1,155,992       1,346,355       1,346,355         Variable interest   entities’ GICs       1,021,791       1,021,791       961,925       961,925         Short-term investments       133,283       133,283       115,596       115,596         VIE short-term   investments       2,674       2,674       1,194       1,194         Cash       10,376       10,376       10,005       10,005         Assets acquired in   refinancing transactions       467,873       460,770       748,936       745,360         Fair value adjustments   on derivatives       491,041       491,041       617,395       617,395         Receivable for   securities sold       1,382       1,382       161       161         Liabilities:                                         Deferred premium   revenue, net of prepaid reinsurance premiums       1,515,408       1,295,312       1,342,057       1,154,461         Losses and loss   adjustment expenses, net of reinsurance recoverable on unpaid losses       169,379       169,379       144,522       144,522         Notes payable to   affiliate       463,575       455,805       753,614       754,463         VIE debt       2,708,773       2,960,686       2,853,963       3,103,090         Surplus notes       108,850       N/A       108,850       N/A         Payable for investments   purchased       28,947       28,947       16,533       16,533         Fair value adjustments   on derivatives       1,060       1,060       —       —         Off-balance-sheet instruments:                                         Installment premiums       —       562,404       —       509,138                          26    15.   LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES Activity in the liability for losses and loss adjustment expenses, which consists of the case and non-specific reserves, is summarized as follows (in millions):             Case Reserve Activity for the   Year Ended December 31,                 2005       2004       2003         Gross balance at   January 1       $   80.6       $   121.9       $   134.0         Less Reinsurance   recoverable       35.4       59.2       76.0         Net balance at   January 1       45.2       62.7       58.0         Transfer from   non-specific reserve       10.3       30.7       12.7         Restructured   transactions       —       (13.9   )   (2.2   )     Paid (net of recoveries)   related to:                                 Current year       —       —       —         Prior year       (2.0   )   (34.3   )   (5.8   )     Total paid       (2.0   )   (34.3   )   (5.8   )     Net balance at   December 31       53.5       45.2       62.7         Plus reinsurance   recoverable       36.3       35.4       59.2         Gross balance at   December 31       $   89.8       $   80.6       $   121.9                       Non-Specific Reserve Activity   For the Year Ended December 31,                     2005               2004               2003             Balance at   January 1           $   99.3               $   111.5               $   89.7             Provision for losses:                                                         Current year           20.4               20.4               22.4             Prior year           5.0               0.2               12.1             Transfers to case   reserves           (10.3   )           (30.7   )           (12.7   )         Restructured   transactions           1.5               (2.1   )           —             Balance at December 31           115.9               99.3               111.5             Total case and non-specific reserves           $   205.7               $   179.9               $   233.4               The gross and net par amounts outstanding on transactions with case reserves were $612.7 million and $519.5 million, respectively, at December 31, 2005. The net case reserve consisted primarily of seven CDO transactions and one municipal transaction, which collectively accounted for approximately 94% of the total net case reserve. The remaining 11 exposures were in various sectors. During 2005, the Company charged $25.4 million to loss expense, consisting of $20.4 million for originations of new business and $5.0 million related to accretion on in-force business. Case reserves increased $8.3 million primarily due to deterioration of specific CDO risks. During 2004, the Company charged $20.6 million to loss expense, consisting of $20.4 million for originations of new business, $4.6 million for accretion related to prior years and $3.2 million related to reassumptions of previously ceded business, offset by reserve releases primarily related to a large refinancing transaction in 2004. The non-specific reserves decreased $12.2 million in 2004, primarily due to transfers from the non-specific reserve to the case reserves of $30.7 million offset by loss expense of $20.6 million. Case reserves decreased $17.5 million due to (1) a large, voluntarily accelerated transaction that had a $34.3 million payment and (2) reclassifications from reserves to asset valuation accounts for refinanced transactions of $13.9 million, partially offset by transfers from the non-specific reserve of $30.7 million. (See Note 18). In September 2004, FSA exercised its rights to have the collateral of a defaulted collateralized bond obligation liquidated at a public sale, in which the Company offered the highest bid. The Company acquired the collateral to gain control of the portfolio in order to mitigate future losses. The previously established case reserve was drawn down to reflect the excess of the purchase amount over the fair value of  27    the collateral. The remaining $9.5 million balance in the case reserve related to this transaction was returned to the non-specific reserve. After reevaluating its requirements for the CDO portion of the non-specific reserve, the Company then reduced the non-specific reserve by $9.5 million, which was partially offset by normal reserve additions. The net amount transferred from the case reserves to the non-specific reserve was $1.4 million, which also included a transfer from the non-specific to the case reserves for a municipal utility transaction. The CDO portfolio continues to perform within the expectations reflected in previously recorded provisions for CDOs. During 2003, the Company charged $34.5 million to loss expense, comprising $9.2 million related to the CDO portfolio discussed below, $22.4 million for origination of new business and $2.9 million for the accretion of the discount on prior years’ reserves. The non-specific reserve increased by $21.8 million in 2003, consisting of the loss expense, a transfer to the non-specific reserve of $1.4 million representing recoveries received on prior-year transactions and a transfer of $14.1 million from the non-specific reserve to case reserves. In addition, the Company reclassified $2.2 million of case reserves as an asset valuation account relating to a restructured transaction involving securitized loans. (see Note 18). Since case and non-specific reserves are based on estimates, there can be no assurance that the ultimate liability will not differ from such estimates. The Company will continue, on an ongoing basis, to monitor these reserves and may periodically adjust such reserves, upward or downward, based on the Company’s actual loss experience, its future mix of business and future economic conditions. Impact of Hurricanes The Company evaluated its insured portfolio to assess the potential impact of Hurricanes Katrina, Rita and Wilma, which occurred in 2005. The Company records a non-specific reserve to reflect the credit risks inherent in its portfolio. Together, the non-specific reserve and case reserves represent the Company’s estimate of total loss liability. The Company believes that its total loss liability is adequate given the current information. Generally, when an insured credit deteriorates to a point where unreimbursed claims are expected, a case reserve is established. As of March 24, 2006, the Company had not received notice of payment default on any exposures related to Hurricanes Katrina, Rita, or Wilma. To date, based on the Company’s review of its exposure, 11 credits, with aggregate net par exposure of $215.8 million, have the most significant risk of loss. FSA-insured bonds are protected by various sources of support that would be invoked before FSA would incur losses. These sources include access to pledged taxes or revenues, reserve funds, property and casualty insurance and state and federal monies. In the case of perpetual obligations the Company may experience claims, but if the population returns in adequate numbers, reimbursement is likely. Eight of the 11 obligations with significant risk of loss are perpetual. The Company monitors its exposure to Hurricanes Katrina and Rita in Louisiana and Mississippi and has determined that no case reserve is required. Of the 11 credits with significant risk of loss, the Company has identified two high priority risks. These risks are perpetual obligations, on which the Company may have to pay claims of up to $44.0 million in a worst-case scenario. However, in these two cases the Company expects that, so long as the population returns in adequate numbers, it would suffer only the lost interest income on any claims paid until the issuer repaid the Company at some point in the future. In order for a community in Louisiana to restructure and potentially reduce its indebtedness, the Bond Commission, which is headed by the State Treasurer, must authorize such action. The State Treasurer has publicly represented that the Bond Commission will not permit any Louisiana municipality to declare bankruptcy. Municipalities in Mississippi are not authorized to file for bankruptcy and therefore have no mechanism under law to adjust their payment obligations. Unlike the corporate market, the municipal market has no private or equity source of capital and therefore lacks any means of starting fresh with a clean slate with debts and liabilities rejected or adjusted in bankruptcy. To file for bankruptcy, or to leave rated indebtedness unpaid in a bankruptcy proceeding, would serve to tarnish the issuer and the region  28    and effectively deny the subject municipality and similar issuers of debt within the state access to capital. Historically, rather than bankruptcy and adjustment of debt, financially distressed municipalities have been subjected to supervision and control by state-created authorities that act both as issuers of debt, secured by a discrete, newly identified revenue stream, and as fiscal monitors. Both the federal government and the executive and legislative branches of the affected states have considered or are expected to consider proposals or legislation to assist the municipalities and facilitate recovery. An example of such an enactment at the federal level is the Community Disaster Loan Act of 2005, under which the federal government has begun to make loans to affected municipalities. In addition, FSA’s asset-backed transactions, which are generally backed by pools of geographically diverse assets , show no unusual concentrations in the affected areas. The loss estimation process involves the exercise of considerable judgment and therefore FSA’s ultimate hurricane-related losses may be materially different from the current estimate and may affect future operating results. 16.   EQUITY INVESTMENTS FSA’s 13% investment in preferred shares of  XL Financial Assurance Ltd (“XLFA”), a financial guaranty insurance subsidiary of XL, is redeemable by XLFA at a price equal to the fair market value of the preferred shares, subject to a cap defined as the internal rate of return of 19% per annum from the date of the investment through the date of redemption, plus accrued dividends as if 100% of current year earnings were distributed. Based on this formula, in 2004,  the Company adopted a policy of carrying this investment at the lesser of the current calculated redemption value or the redemption value as of the next January first, which would exclude its share of accrued current year earnings to the extent the cap had been otherwise met. Consistent with this policy, in the third quarter of 2004, the Company charged $11.7 million to equity in earnings of unconsolidated affiliates and reduced its carrying value in this investment to $56.4 million. Until the fourth quarter of 2004 this investment was accounted for using the equity method of accounting because the Company has significant influence over XLFA’s operations. In the second quarter of 2004, the Emerging Issues Task Force (“EITF”) reached a consensus that under EITF Issue 02-14, “Whether an Investor Should Apply the Equity of Method of Accounting to Investments Other Than Common Stock” (“EITF 02-14”), an investor should only apply the equity method of accounting when it has investments in either common stock or in-substance common stock of a corporation, provided that the investor has the ability to exercise significant influence over the operating and financial policies of the investee. The EITF 02-14 consensus is applicable to reporting periods beginning after September 15, 2004. In accordance with this consensus, the Company no longer accrues undistributed earnings related to its investment in XLFA. Amounts recorded by the Company in connection with XLFA as of December 31, 2005, 2004 and 2003 are as follows (in thousands):             2005       2004       2003         Equity securities       $54,300       $54,300       —         Investment in XLFA       —       —       $64,440         Equity in earnings from   XLFA       —       3,761       19,077         Dividends earned from XLFA       8,926       14,103       6,640           17.   MINORITY INTEREST IN SUBSIDIARY In 1998, the Company and XL entered into a joint venture, establishing two Bermuda domiciled financial guaranty insurance companies—FSA International and XLFA. At December 31, 2004, XL owned a minority interest in FSA International and the Company owned a minority interest in XLFA. In October 2005, FSA purchased all the preferred shares of FSA International owned by XL Insurance (Bermuda), Ltd. for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect  29    wholly owned subsidiary of the Company. The preferred shares were Cumulative Participating Voting Preferred Shares that, in total, had a minimum fixed dividend of $1.5 million per annum. In 2005, 2004 and 2003, FSA International paid preferred dividends of $16.3 million, $7.0 million and $3.3 million, respectively, to XL. For the years ended December 31, 2005, 2004 and 2003, the Company recognized minority interest of $6.9 million, $7.0 million and $9.3 million, respectively. 18.   REFINANCED TRANSACTIONS AND NOTES PAYABLE TO AFFILIATES The Company generally has rights under its financial guaranty insurance policies and indentures that allow it to accelerate the insured notes and pay claims under its insurance policies upon the occurrence of predefined events of default. To mitigate future losses, the Company may elect to purchase the outstanding insured obligation or its underlying collateral. Generally, refinancing vehicles reimburse FSA in whole for its claims payments in exchange for assignments of certain of FSA’s rights against the trusts. The refinancing vehicles obtain their funds from the proceeds of FSA-insured GICs issued in the ordinary course of business by the GIC Affiliates. The refinancing vehicles are consolidated into the Company’s financial statements. The Company maintains its reinsurance on these transactions. The following table presents the components of the assets acquired in refinancing transactions (in thousands):             As of December 31,                 2005       2004         Assets acquired in refinancing transactions                         Securitized loans       $   296,965       $   369,750         Bonds       9,145       157,036         Asset-backed senior   notes       59,276       89,913         Equity securities       3,488       15,659         Mortgage loans       56,165       77,462         Short term investments       37,512       27,749         Other       5,322       11,367         Total       $   467,873       $   748,936           30       Securitized loans are carried at cost, net of losses at the date of purchase. Income is recorded based on the effective yield method. The accretable yield on the securitized loans at December 31, 2005, 2004, and 2003 was $142.3 million, $145.7 million, and $147.2 million, respectively. The cash flows on the securitized loans, net of reinsurance, are monitored and the effective yield modified to reflect any change in the cash flow estimate on a prospective basis. Since the notes represent 100% of the debt capitalization of the trusts and since FSA maintains all the risk of further asset decline (except as provided by reinsurance) and maintains control over key decisions regarding the trusts (such as removal of the servicer, sale of the assets and liquidation of the entity), the trusts were consolidated with the Company for accounting purposes. The Company also consolidated the refinancing vehicles. Bonds, equity securities and mortgage loans represent liquidations of previously insured obligations and subsequent purchases of the underlying collateral. Bonds and equity securities are available for sale and carried at fair value. At December 31, 2005, there were no securities in the refinanced asset portfolio in an unrealized loss position for a continuous 12-month period or longer. At December 31, 2005, the Company determined that no investments were considered other-than-temporarily impaired. The credit quality of bonds within the refinanced asset portfolio at December 31, 2005 was as follows:     Rating(1)               Percent of Bonds         BBB           19.0   %         CCC           67.6             D            5.4             NR           8.0                         100.0%              (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. The amortized cost and fair-value of fixed income assets within the refinanced asset portfolio were as follows (in thousands):             As of December 31, 2005                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Corporate securities       $   5,946           $   3,199               —           $   9,145         Asset-backed   securities       59,920           —               (644   )       59,276         Short-term   investments       37,512           —               —           37,512         Total       $   103,378           $   3,199               $   (644   )       $   105,933                                           As of December 31, 2004                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Corporate securities       $   151,895           $   5,743               $   (602   )       $   157,036         Asset-backed   securities       89,500           1,016               —           90,516         Short-term   investments       27,749           —               —           27,749         Total       $   269,144           $   6,759               $   (602   )       $   275,301           The amortized cost and fair value of equities held within the refinanced asset portfolio were as follows (in thousands):             As of December 31, 2005                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Equity securities           $   2,206               $   1,282               —               $   3,488                                      31                  As of December 31, 2004                 Amortized   Cost       Gross   Unrealized   Gains       Gross   Unrealized   Losses       Fair Value         Equity securities           $   13,919               $   1,903               (163   )           $   15,659                                      The amortized cost and fair-value of fixed income assets within the refinanced asset portfolio at December 31, 2005, are shown below by contractual maturity (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized Cost       Fair Value         Due in one year or less           $   37,967           $   37,982         Due after one year   through five years           17,906           17,906         Due after five years   through ten years           47,505           50,045         Total           $   103,378           $   105,933           At December 31, 2005, there were no securities in an unrealized loss position for a continuous 12-month period or longer. The Company determined that there were six securities considered other-than-temporarily impaired. For 2005, a $4.5 million impairment was recorded in the statement of operations and comprehensive income. The Company has recorded $463.6 million of notes payable to an affiliate at December 31, 2005 and $753.6 million at December 31, 2004. For the years ended December 31, 2005, 2004 and 2003 the Company recorded $28.2 million, $24.8 million and $24.1 million, respectively, of interest expense on the notes payable. Principal payments due under these notes for each of the next five years ending December 31 and thereafter are as follows (in thousands):     Expected Withdrawal Date               Principal   Amount         2006       $   51,785         2007       71,358         2008       56,291         2009       50,401         2010       44,237         Thereafter       189,503         Total       $   463,575           19.   DERIVATIVE INSTRUMENTS Credit Default Swaps The Company has insured a number of CDS with the expectation that these transactions will not be subject to a market value termination for which the Company would be liable. It considers these agreements to be a normal extension of its financial guaranty insurance business, although they are considered derivatives for accounting purposes. These agreements are recorded at fair value. The Company believes that the most meaningful presentation of the financial statement impact of these derivatives is to reflect premiums as installments are received, to record losses and loss adjustment expenses as incurred and to record changes in fair value as incurred. The Company recorded $89.2 million, $69.1 million and $57.7 million of net earned premium under these agreements for the years ended 2005, 2004 and 2003, respectively. Changes in the fair value of CDS, which were gains of $11.1 million, $56.4 million and $34.8 million for the years ended December 31, 2005 , 2004, and 2004 respectively, were recorded in net realized and unrealized gains on derivative instruments in the consolidated statements of operations and  32    comprehensive income. The Company included net par outstanding of $66.6 billion and $66.0 billion relating to these CDS transactions at December 31, 2005 and December 31, 2004, respectively, in the asset-backed balances in Note 12. The gains or losses recognized by recording these contracts at fair value are determined each quarter based on quoted market prices, if available. If quoted market prices are not available, then the determination of fair value is based on internally developed estimates. Management applies judgment when developing these estimates and considers factors such as current prices charged for similar agreements, performance of underlying assets, changes in internal shadow ratings, the level at which the deductible has been set and the Company’s ability to obtain reinsurance for its insured obligations. The Company does not believe that the fair-value adjustments are an indication of potential claims under FSA’s guarantees. The average life of these contracts is 3.2 years. The inception-to-date gain (loss) on the CDS portfolio was $57.7 million at December 31, 2005 and $46.6 million at December 31, 2004, and was recorded in other assets. Interest Rate and Foreign Exchange Rate Derivatives The Company enters into derivative contracts to manage interest-rate and foreign currency exposure in its VIE debt and VIE bond portfolio. The derivative contracts are recorded at fair value. These derivatives generally include interest-rate and currency swap agreements, which are primarily utilized to convert fixed-rate debt and investments into U.S. dollar floating-rate debt and investments. The gains and losses related to the fair value of derivatives are included in net realized and unrealized gains (losses) on derivative instruments. The inception-to-date net unrealized gain on the outstanding derivatives held by the VIE’s of $433.7 million and $570.8 million at December 31, 2005 and December 31, 2004, respectively, was recorded in other assets and accrued expenses and other liabilities as applicable. 20.   VARIABLE INTEREST ENTITIES The Company adopted FIN 46 and consolidated for financial reporting purposes, effective July 1, 2003, FSA Global and Canadian Global. In addition, as a result of the Company obtaining control rights of another VIE, Premier, on July 1, 2003, the Company consolidated Premier beginning July 1, 2003. FIN 46R requires that, upon consolidation, the Company initially measure the VIE’s assets, liabilities and minority interest at their carrying amounts under existing GAAP as if the entity had been consolidated from the time the Company was considered its primary beneficiary (or parent). The increase in total assets and total liabilities related to the consolidation of these entities was $2.9 billion. Any differences upon consolidation were reflected as a cumulative effect of a change in accounting principle. The cumulative effect of a change in accounting principle for Canadian Global resulted in additional income of $4.8 million, net of income tax. There were no cumulative income statement effects from consolidating FSA Global and Premier. FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the issuance of FSA-guaranteed notes are invested in obligations having cash flows substantially matched to those of, and maturing prior to, such notes. In certain cases, investments of FSA Global consist of GICs issued by the GIC Affiliates. Similarly, Premier holds GICs issued by the GIC Affiliates in their investment portfolios. The Company’s management believes that the assets held by the VIEs, including those that are eliminated in consolidation with the Parent, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. All intercompany insured amounts between FSA and FSA Global and Canadian Global previously included in the Company’s outstanding exposure are excluded from the Notes  33     to the Condensed Consolidated Financial Statements for December 31, 2005 and 2004. During the third quarter of 2004, the majority of the assets and liabilities of Canadian Global were satisfied.             2005       2004         VIE net interest   income       $   105,561       $   74,286         FSA’s net   premiums earned on VIE’ bonds and debt       (3,613   )   (5,351   )     Net realized and   unrealized gains (losses) on derivatives       (133,915   )   249,752         Total revenues       $   (31,967   )   $   318,687         VIE net interest   expense       $   124,218       $   126,793         Other operating   expenses       50       (825   )     Foreign exchange   loss       (162,398   )   79,270         Total expenses       $   (38,130   )   $   205,238           VIE Investments All bonds in the VIE Portfolio are insured by FSA. The credit quality of the VIE Portfolio, without the benefit of FSA’s insurance, at December 31, 2005 was as follows:     Rating(1)               Percent   of Bonds         AAA           2.3   %         A            95.5             BB           2.2                         100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available at December 31, 2005. Excludes VIE GICs. All VIE GICs are FSA-insured. The amortized cost and fair value of bonds in the VIE Portfolio were as follows (in thousands):     December 31, 2005               Amortized   Cost       Fair Value         Obligations of   states and political subdivisions       $   15,879       $   15,879         Corporate   securities       20,013       19,327         Foreign       8,995       9,841         Asset-backed   securities(1)       1,110,945       1,110,945         Short-term   investments       2,674       2,674         Total       $   1,158,506       $   1,158,666               December 31, 2004               Amortized   Cost       Fair Value         Obligations of   states and political subdivisions       $   16,007       $   16,007         Corporate   securities       156,030       157,990         Foreign       56,077       57,983         Asset-backed   securities(1)       1,114,375       1,114,375         Short-term   investments       1,194       1,194         Total       $   1,343,683       $   1,347,549          (1)          Asset-backed securities consist of floating-rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation. Management believes that amortized cost closely approximates fair value for these securities. 34    The Company periodically monitors its investment portfolio for individual investments in an unrealized loss position in order to assess whether that investment is considered other-than-temporarily impaired. In each case, the Company determines the nature and cause of the decline and whether the Company maintains the ability and intent to hold the security until the unrealized loss may reverse or until maturity. At December 31, 2005, there were no securities in an unrealized loss position. The Company determined that no investments were considered other-than-temporarily impaired. The amortized cost and fair value of bonds in the VIE Portfolio at December 31, 2005, by contractual maturity, are shown below (in thousands). Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             Amortized Cost       Fair Value         Due in one year   or less           $   2,674           $   2,674         Due after one   year through five years           29,008           29,168         Due after five   years through ten years           —           —         Due after ten   years           15,879           15,879         Asset-backed   securities (stated maturities of 4 to 17 years)           1,110,945           1,110,945         Total           $   1,158,506           $   1,158,666           At December 31, 2005, the interest rates on VIE Debt were between 1.12% and 6.61% per annum. The amortized cost and fair value of GICs held within the VIE guaranteed investment portfolio were as follows (in thousands):             Amortized Cost       Fair Value         Due in one year   or less           $   79,000           $   79,000         Due after one   year through five years           613,367           613,367         Due after five   years through ten years           52,744           52,744         Due after ten   years           276,680           276,680         Total           $   1,021,791           $   1,021,791           Payments due under the VIE Debt (including $1,081.8 million of interest accretion on zero coupon obligations) in each of the next five years ending December 31 and thereafter, are as follows (in thousands):     Year               Principal   Amount         2006       $   87.8         2007       552.6         2008       128.6         2009       17.6         2010       94.4         Thereafter       2,909.6         Total       $   3,790.6           35    21.   OTHER ASSETS The detailed balances that comprise other assets at December 31, 2005 and 2004 are as follows (in thousands):     Other assets:       2005       2004         Fair value of VIE   derivatives       $   433,670       $   570,764         VIE other   invested assets       266,978       156,540         Tax and loss   bonds       105,324       102,193         Accrued interest   on VIE derivatives       108,421       99,794         Accrued interest   income       53,101       50,632         Other assets       195,068       145,696         Total other assets       $   1,162,562       $   1,125,619           22.   RECENTLY ISSUED ACCOUNTING STANDARDS In February 2006, the FASB issued Statement of Financial Accounting Standards No.155 “Accounting for Certain Hybrid Financial Instruments (“SFAS 155”). SFAS 155 provides guidance with respect to bifurcation of embedded credit risk in a special purpose entity. The adoption of SFAS 155 is not expected to have a material impact on the Company’s financial position or results of operations. In November 2005, the FASB issued FASB Staff Position (FSP) 115-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” which supersedes certain requirements of EITF 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and amends SFAS 115 and Accounting Principles Board Opinion (APB) 18, “The Equity Method of Accounting for Investments in Common Stocks.” FSP 115-1 outlines a three-step model to identify investment impairments in each reporting period. First, for each reporting period, individual securities are determined to be impaired if the fair value of a security is less than its cost. Second, impaired securities are evaluated as to whether the impairment is other than temporary based on existing applicable guidance. Lastly, if the impairment is other than temporary, an impairment loss is recognized in earnings equal to the difference between the investment’s cost and fair value as of the reporting date. Under FSP 115-1, the disclosure requirements required by EITF 03-1 issued in December 2003 remain in effect. EITF 03-1 requires the Company to disclose certain information about unrealized losses on its investment portfolio that have not been recognized as other-than-temporary impairments. The requirements under FSP 115-1 are effective for reporting periods beginning after December 15, 2005. The Company believes that the adoption of FSP 115-1 will not have a material effect on the Company’s financial position or results of operations. See Note 3 for disclosures required by EITF 03-1. In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123-R, “Share-Based Payment” (“SFAS 123-R”). This Statement is a revision of SFAS 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and its related implementation guidance. SFAS 123-R requires entities to recognize compensation cost for all equity-classified awards after the effective date using the fair-value measurement method. SFAS 123-R is effective for annual periods beginning after June 15, 2005. The adoption of SFAS 123-R is not expected to have a material impact on the Company’s financial position or results of operations. 36        -----END PRIVACY-ENHANCED MESSAGE-----
Principal Accounting Fees and Services       135     PART IV
Exhibits, Financial Statement Schedules       136           PART I Item 1.                        Business. Financial Security Assurance Holdings Ltd., through its insurance company subsidiaries, is primarily engaged in the business of providing financial guaranty insurance on municipal and asset-backed obligations in domestic and international markets. The financial strength of the Company’s insurance company subsidiaries is rated “Triple-A” by the major securities rating agencies and obligations insured by them are generally awarded “Triple-A” ratings by reason of such insurance. The Company’s principal insurance company subsidiary is Financial Security Assurance Inc. (“FSA”), a wholly owned New York insurance company. FSA was the first insurance company organized to insure non-municipal obligations and has been a major insurer of asset-backed and other non-municipal obligations since its inception in 1985. FSA expanded the focus of its business in 1990 to include financial guaranty insurance of municipal obligations and has since become a major insurer of municipal obligations. In addition, the Company offers FSA-insured guaranteed investment contracts and other investment agreements (“GICs”) through other consolidated entities. References to the “Company” are to Financial Security Assurance Holdings Ltd. together with its subsidiaries. Financial guaranty insurance written by FSA typically guarantees scheduled payments on financial obligations. Upon a payment default on an insured obligation, FSA is generally required to pay the principal, interest or other amounts due in accordance with the obligation’s original payment schedule or may, at its option, pay such amounts on an accelerated basis. FSA’s underwriting policy is to insure obligations that would otherwise be investment grade without the benefit of FSA’s insurance. For the year ended December 31, 2005, the Company had gross premiums written of $833.8 million, of which approximately 70% related to insurance of municipal obligations and approximately 30% related to insurance of asset-backed and other non-municipal obligations. As of December 31, 2005, the Company had net par outstanding of $337.5 billion, of which approximately 67% represented insurance of municipal obligations and approximately 33% represented insurance of asset-backed and other non-municipal obligations. The Company provides FSA-insured GICs to municipalities and other market participants. As of December 31, 2005, the Company had $12.7 billion principal amount of outstanding GICs. Organization FSA wholly owns FSA Insurance Company (“FSAIC”), which in turn wholly owns Financial Security Assurance (U.K.) Limited (“FSA-UK”). FSA and FSAIC together own Financial Security Assurance International Ltd. (“FSA International”). FSAIC is an Oklahoma insurance company that primarily provides reinsurance to FSA. FSA-UK is a United Kingdom insurance company that primarily provides financial guaranty insurance for transactions in the United Kingdom and other European markets. FSA International is a Bermuda insurance company that provides reinsurance to FSA and financial guaranty insurance for transactions outside United States and European markets. The Company conducts its GIC business through its affiliates FSA Capital Management Services LLC (“FSACM”), FSA Capital Markets Services (Caymans) Ltd. and, prior to April 2003, FSA Capital Markets Services LLC (collectively, the “GIC Affiliates”). The Company consolidates the results of the GIC Affiliates. FSACM has conducted substantially all of the Company’s GIC business since April 2003, following its receipt of an exemption from the requirements of the Investment Company Act of 1940. The GIC Affiliates lend the proceeds from their sales of GICs to FSA Asset Management LLC (“FSAM”), which invests the funds, generally in obligations that qualify for FSA insurance. The Company consolidates the results of certain variable interest entities (“VIEs”), including FSA Global Funding Limited (“FSA Global”), Premier International Funding Co. (“Premier”), and Canadian  3    Global Funding Corporation (“Canadian Global”). FSA Global is a special purpose funding vehicle 29% owned by the Company. FSA Global issues FSA-insured medium term notes and invests the proceeds from the sale of its notes in FSA-insured obligations with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. Premier is principally engaged in debt defeasance for lease transactions. The majority of Canadian Global’s assets were liquidated and its liabilities satisfied during the third quarter of 2004. The Company refinances certain defaulted transactions by employing special purpose vehicles to raise funds to refinance such transactions. These refinancing vehicles are also consolidated. The Company’s management believes that the assets held by FSA Global, Premier and the refinancing vehicles, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Variable Interest Entities.” FSA Portfolio Management Inc. (“FSA Portfolio Management”), a wholly owned subsidiary of the Company, is engaged in the business of managing a portion of the investment portfolios of the Company and certain of its subsidiaries. FSA Portfolio Management also owns various strategic and other investments funded from time to time by the FSA group of companies. Transaction Services Corporation (“TSC”), a wholly owned subsidiary of the Company, is engaged in the business of managing workout transactions, including, but not limited to, those referred to as refinanced transactions, within the insured portfolios of FSA and its subsidiaries. The Company is a subsidiary of Dexia Holdings, Inc. (“Dexia Holdings”), which, in turn, is owned 90% by Dexia Crédit Local S.A. (“Dexia Crédit Local”) and 10% by Dexia S.A. (“Dexia”). Dexia is a Belgian corporation whose shares are traded on the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. Dexia is primarily engaged in the business of public finance, banking and investment management in France, Belgium, Luxembourg and other European countries, as well as in the United States. Dexia Crédit Local is a wholly owned subsidiary of Dexia. The Company’s Executive Management Committee manages the Company’s business. The Chief Executive Officer, President, General Counsel, Chief Risk Management Officer and Chief Financial Officer are members of the Executive Management Committee. The heads of Municipal Finance, Corporate Finance, the European Group, the Asia Group and Financial Products serve as part-time members of this committee and, collectively, comprise the “Management Committee.”  Bruno Deletre, a director of the Company and a member of the Executive Board of Dexia Crédit Local, is an ex officio member of the Management Committee. History When the Company commenced operations in 1985, it was owned by a number of large insurance companies and other institutional investors. In 1989, the Company was acquired by U S WEST Capital Corporation, which subsequently changed its name to MediaOne Capital Corporation (“MediaOne”). MediaOne was a subsidiary of MediaOne Group, Inc., with operations and investments in domestic cable and broadband communications and international broadband and wireless communication. In 1990, the Company established a strategic relationship with The Tokio Marine and Nichido Fire Insurance Co., Ltd. (“Tokio Marine”), which acquired a minority interest in the Company. Tokio Marine is a major Japanese property and casualty insurance company. In 1994, the Company completed an initial public offering of common shares, at which time White Mountains Insurance Group, Ltd. (“White Mountains”) (formerly known as Fund American Enterprises Holdings, Inc.) made an investment in the Company, and the chairman of White Mountains became non-executive chairman of the Company. White Mountains is an insurance holding company. 4    In 1998, the Company and XL Capital Ltd (“XL”), a major Bermuda-based insurance holding company, entered into a joint venture, establishing two Bermuda domiciled financial guaranty insurance companies—FSA International and XL Financial Assurance Ltd (“XLFA”). In connection with the joint venture, XL acquired a minority interest in the Company and FSA International, and the Company acquired a minority interest in XLFA. On July 5, 2000, the Company completed a merger in which the Company became a direct subsidiary of Dexia Holdings. At the merger date, each outstanding share of the Company’s common stock was converted into the right to receive $76.00 in cash. As of December 31, 2005, approximately 99% of the Company’s common stock was held by Dexia Holdings. The other holders are a White Mountains affiliate and certain directors of the Company who own shares of the Company’s common stock or economic interests therein as described under “Item 11. Executive Compensation—Director Share Purchase Program.”  Dexia is required to repurchase the shares of the Company held by White Mountain’s affiliate in May 2006. In October 2005, FSA purchased the interest in FSA International owned by XL for a cash purchase price of $39.1 million in anticipation of the repatriation of earnings and profits of FSA International. Giving effect to such purchase, FSA International became an indirect wholly owned subsidiary of the Company. Although the Company’s common stock is no longer listed on the New York Stock Exchange (“NYSE”) as a consequence of the merger, the Company continues to file periodic reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), because the Company has debt securities listed on the NYSE. The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019. Subsidiaries of the Company maintain offices domestically in San Francisco and Dallas and abroad in London, Madrid, Mexico City, Paris, Singapore, Sydney, Tokyo and Bermuda. Business Objectives Financial Guaranty Business The Company’s objective for its financial guaranty business is to remain a leading insurer of municipal and asset-backed obligations while generating premium volume at attractive returns and minimizing the occurrence and severity of credit losses in its insured portfolio. The Company believes that the demand for financial guaranty insurance will remain strong over the long term as a result of the anticipated continuation of the following trends: ·       growth of asset securitization; ·       growth of project finance in Europe and the United States through expansion of private finance for funding of infrastructure projects; ·       substantial volume of new domestic municipal bonds that are insured, due, in part, to the continued use of municipal bonds to finance repairs and improvements to the nation’s infrastructure and continued demand for credit enhancement by individuals who purchase municipal bonds; and ·       growing use of financial guaranty insurance in non-U.S. markets. The Company believes that short term trends for financial guaranty insurance remain uncertain due, among other things, to: ·       narrow interest rate spreads between Triple-A rated obligations and lower rated obligations; ·       potential decline in municipal financings and refundings should interest rates rise; and 5    ·       increased competition among financial guarantors and other alternative providers of credit enhancement. The Company expects to continue to originate a diversified insured portfolio characterized by insurance of both municipal and asset-backed obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. In addition to its domestic business, the Company selectively pursues international opportunities, primarily in Western European and Asia Pacific markets. Financial Products Business The Company’s objective for its financial products (“FP”) business is to generate net interest margin through borrowing funds at attractive rates in the municipal GIC and other markets and investing the proceeds in obligations satisfying the Company’s underwriting criteria while minimizing the Company’s exposure to interest rate changes. The Company anticipates continued demand over the long term for its GIC business and other financial products programs that employ financial guaranty insurance provided by FSA. The Company’s ability to continue or grow its financial products business, however, is subject to the conclusion of a review underway by Moody’s Investors Service, Inc. (“Moody’s”) of the non-core business activities of financial guaranty insurers. Business of the Company The Company is engaged in the financial guaranty business through its insurance company subsidiaries and in the FP business through its GIC Affiliates and FSAM (collectively, the “FP Segment”). Financial Guaranty Business FSA’s insurance is employed in both the new issue and secondary markets. In the case of new issues, the insured obligations are sold with FSA insurance at the time the obligations are issued. For both municipal and asset-backed obligations, FSA participates in negotiated offerings, where the investment banker and often the insurer have been selected by the sponsor or issuer. In addition, FSA participates in competitive offerings, where underwriting syndicates bid for securities and submit bids that may include insurance. FSA’s Custody Receipt Program provides insurance for municipal obligations trading in the secondary market. Likewise, FSA’s Triple-A Guaranteed Secondary Securities (“TAGSS”®) Program provides insurance for asset-backed obligations trading in the secondary market. Investors and dealers generally obtain secondary-market insurance to upgrade or stabilize the credit ratings of securities they already hold or plan to acquire or to increase the market liquidity of such securities. FSA’s underwriting guidelines require the same underwriting standards on secondary market issues as on new issues, although FSA’s control rights in the event of default are generally more limited. In many insured transactions, the issuer of insured securities is party to an interest rate, basis or currency swap that matches the issuer’s funding sources to the interest rate or currency of the insured securities or otherwise hedges the issuer’s exposure. In such transactions, FSA typically insures the issuer’s obligations under both the insured securities and the derivative contract. FSA insures payment obligations of counterparties and issuers under GICs, GIC equivalents, credit-linked notes and obligations under interest rate, currency and credit default swaps (“CDS”), including guaranties issued in connection with the Company’s FP Segment. FSA also issues surety bonds under its Sure-Bid program, which provides an alternative to traditional types of good faith deposits for competitive municipal bond transactions. FSA insures obligations already carrying insurance from other monoline guarantors, with FSA generally obligated to pay claims on a “second-to-pay” basis, following a default by both the underlying  6    obligor and the first-to-pay financial guarantor. In recent years, FSA has reinsured a modest amount of business from other financial guaranty insurers. The following table indicates the Company’s percentages of par amount (net of reinsurance) outstanding as of December 31, 2005 and 2004 with respect to each type of municipal and asset-backed program: Net Par Amount and Percentage Outstanding by Program Type             As of December 31, 2005(1)                 Municipal Programs       Asset-Backed Programs                 Net Par   Amount   Outstanding(1)       Percent of   Total Net Par   Amount   Outstanding       Net Par   Amount   Outstanding       Percent of   Total Net Par   Amount   Outstanding                 (in millions)         New Issue           $   217,405               95.7   %           $   102,464               92.8   %         Secondary Market           8,112               3.6               6,985               6.3             Assumed           1,543               0.7               974               0.9             Total           $   227,060               100.0   %           $   110,423               100.0   %                       As of December 31, 2004(1)                 Municipal Programs       Asset-Backed Programs                 Net Par   Amount   Outstanding(1)       Percent of   Total Net Par   Amount   Outstanding       Net Par   Amount   Outstanding       Percent of   Total Net Par   Amount   Outstanding                 (in millions)         New Issue           $   186,090               95.3   %           $   112,808               92.2   %         Secondary Market           8,240               4.2               8,496               6.9             Assumed           1,062               0.5               1,046               0.9             Total           $   195,392               100.0   %           $   122,350               100.0   %          (1)          Excludes intercompany insurance of $13,463 million in 2005 and $7,143 million in 2004 relating to FSA-insured GICs issued by the GIC Affiliates. Premiums In setting insurance premium rates, FSA takes into account the risk it assumes and its projected return. Critical factors in assessing risk include the credit quality of the issuer, type of issue, sources of repayment, transaction structure and term to maturity. The premium rate is also a function of market factors and the competitive environment. Market factors include the value added by the use of insurance, such as the interest rate savings the issuer of an insured obligation obtains. Competition arises from other insurers and alternative executions that do not involve insurance. For insurance on GIC and medium term note transactions, transactions involving “repackaging” of outstanding securities and other transactions, FSA’s premium may be arbitrage-based, based upon the difference between the effective borrowing cost at a Triple-A rate and the interest rate on the underlying securities. Municipal Obligations FSA insures a range of municipal obligations, including: ·       general obligation bonds supported by the issuers’ taxing power; 7    ·       revenue bonds and other obligations of state and local governments supported by the issuers’ ability to impose and collect fees and charges for public services or specific projects such as utility revenues; ·       project finance obligations, consisting primarily of obligations of special purpose issuers backed by the cash flow from lease or other revenues from projects serving a substantial public purpose, including government office buildings, toll roads, healthcare facilities and utilities; ·       payment obligations of counterparties under CDS referencing municipal obligations; and ·       payment obligations of municipal counterparties under interest rate swaps or other derivatives. Municipal obligations include bonds, notes and other indebtedness issued by public and quasi-public entities, including states and their political subdivisions (such as counties, cities or towns), utility districts, public universities and hospitals, and public housing and transportation authorities. Municipal obligations also include bonds, notes and other indebtedness issued by special purpose entities established to finance investments in infrastructure projects. An issuer’s obligation to pay is supported by the issuer’s taxing power in the case of general obligation bonds, and by the issuer’s ability to impose and collect fees and charges for public services or specific projects in the case of most revenue bonds and public-private infrastructure financings. Some municipal obligations, including most project finance obligations, include non-municipal credit risks (to swap counterparties, insurance companies, construction companies or other non-municipal credits) and operating risks (such as traffic volume or tuition revenues). According to industry sources, the total and insured volume since 2001 of long-term U.S. municipal new issues sold were as follows: U.S. Municipal Obligations(1)     Year               New Total Volume       New Insured Volume       New Insured Volume as   Percent of New Total Volume                 (in billions)         2001           $   288.2               $   131.0               45.5   %         2002           358.8               177.6               49.5             2003           383.7               190.7               49.7             2004           360.1               194.1               53.9             2005           408.4               228.1               55.9              (1)          Source: The Bond Buyer, February 7, 2006. Volume is expressed in terms of principal issued and insured on a sale-date basis. Subject to revision as additional information becomes available. The municipal bond industry saw an increase in new issue volume in 2001, 2002 and 2003, as declining interest rates, diminished tax revenues and continuing needs for infrastructure investment drove municipalities to borrow on an unprecedented scale. Insurance penetration has risen steadily since 2001, reaching its highest historical level in 2005. New insured par volume rose significantly in 2005 due to increased market volume and higher penetration. Outside the United States, guarantors have increased their presence in public infrastructure finance from 2001 levels. International municipal transactions include many public-private partnership financings, such as those authorized by the U.K. Private Finance Initiative, and other highly structured transactions. Because such transactions tend to have long development times and large par amounts, the timing of transactions may cause volatility in insured volume from year to year. 8     Since 2001, the annual totals of non-U.S. municipal par insured of financial guaranty insurance directly originated by monoline guarantors, according to industry sources, were as follows: Non-U.S. Municipal Obligations Insured by Monoline Insurance Companies(1)     Year       Amount                 (in billions)         2001           $   6.0             2002           8.1             2003           13.9             2004           11.7             2005           N/A   (2)          (1)          Source: Association of Financial Guaranty Insurers (“AFGI”) web page, July 2005. Data is subject to revision as additional information becomes available. (2)          Not available from the same source. Of the four largest monoline guarantors, three disclose the municipal component of their international business in their statistical operating supplements. According to such statistical operating supplements, those three companies insured directly or assumed, in the aggregate, a principal amount of $15.7 billion of non-U.S. municipal obligations in 2005. Asset-Backed Obligations Asset-backed obligations insured by FSA are generally issued in structured transactions backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities or other assets having an ascertainable cash flow or market value. Asset-backed obligations insured by FSA also include payment obligations of counterparties and issuers under synthetic obligations such as CDS and credit-linked notes referencing asset-backed securities or pools of securities or other obligations. Asset-backed obligations are typically issued in connection with structured financings or securitizations where the securities being issued are secured by or payable with funds from a specific pool of assets. The assets are typically held by a special purpose entity that also acts as the issuer of the insured obligations. Most asset-backed obligations are secured by or represent interests in diverse pools of assets, such as residential mortgage loans, auto loans, credit card receivables, other consumer receivables, corporate loans or bonds, government debt and small business loans. Asset-backed obligations may also be secured by less diverse payment sources, such as multifamily real estate. Asset-backed obligations include funded and synthetic transactions. Funded asset-backed obligations are typically payable from cash flow generated by a pool of assets and take the form of either “pass-through” obligations, which represent interests in the related assets, or “pay-through” obligations, which generally are debt obligations collateralized by the related assets. Both types of funded asset-backed obligations generally have the benefit of one or more forms of credit enhancement, such as overcollateralization or excess cash flow, to cover credit risks associated with the related assets. Synthetic asset-backed obligations generally take the form of CDS obligations or credit-linked notes that reference either an asset-backed security or pool of securities or loans, with a defined deductible to cover credit risks associated with the referenced securities or loans. Asset securitization often represents an efficient way for commercial banks to comply with capital requirements and for corporations to access the capital markets at more attractive rates and, frequently, with different accounting treatment. Banks have responded to increased capital requirements by selling certain of their assets, such as credit card receivables and automobile loans, in securitized structures to the financial markets. Some corporations have found securitization of their assets to be a less costly funding  9    alternative to traditional forms of borrowing or otherwise important in diversifying funding sources. Many finance companies fund consumer finance and home equity lending through securitization. Since the late 1990s, a significant market has developed for funded and synthetic collateralized debt obligations (“CDOs”), which are securitizations of bonds, loans or other securities. CDOs are used by financial institutions to manage their risk profiles, optimize capital utilization and improve returns on equity. CDOs are also used by dealers or portfolio managers to provide leveraged investments in bond and loan portfolios tailored to conform to differing risk appetites of investors. According to industry sources, the new par volumes since 2001 for each type of funded asset-backed security presented, including securities distributed under Rule 144A under the Securities Act of 1933 (as amended, the “Securities Act”), were as follows:     Year               New Issues of Funded U.S.   Public Asset-Backed   Securities(1)(2)       U.S. Public Issues of   Private-Label   Mortgage-Backed   Securities(1)       Non-U.S. Asset-   Backed Securities(1)(3)       Worldwide Funded   Collateralized Debt   Obligations(1)                 (in billions)         2001           $   324.6               $   143.1               $   115.2               $   79.6             2002           411.5               214.0               117.3               87.7             2003           505.1               297.1               198.8               82.6             2004           688.1               329.1               205.5               127.6             2005           847.6               514.2               263.2               217.2              (1)          Source: Asset-Backed Alert, January 10, 2003, January 9, 2004, January 7, 2005 and January 13, 2006.  Subject to revision as additional information becomes available. (2)          Includes corporate and consumer receivable-backed issues (including home equity loan issues) but excludes private-label mortgage-backed securities, CDOs, commercial paper and private placements not made under Rule 144A. (3)          Includes asset-backed and mortgage-backed securities but excludes CDOs. The data in the above table excludes synthetic transactions and therefore does not reflect the growth in the use of CDS during the years covered. According to the International Swaps and Derivatives Association, Inc. (“ISDA”), the notional principal amount of CDS outstanding in world markets was as follows at the dates indicated:             Outstanding   Credit Default Swaps(1)                 (in billions)         December 31,   2001           $   918.9             December 31,   2002           2,191.6             December 31,   2003           3,779.4             December 31,   2004           8,422.3             June 30, 2005           12,429.9              (1)          Source: ISDA web page, February 22, 2006. According to industry information, the annual totals of funded and synthetic asset-backed par insured of financial guaranty insurance directly originated by monoline guarantors during each year since 2001 were as follows: 10    Asset-Backed Obligations Insured by Monoline Insurance Companies(1)     Year Ended December 31,               United States       Non-U.S.                 (in billions)         2001           $   167.1               $   51.4             2002           165.5               63.2             2003           120.4               45.0             2004           200.0               46.8             2005           N/A   (2)           N/A   (2)          (1)          Source: AFGI web page dated July 2005. Includes all funded and synthetic primary-market and secondary-market U.S. insured transactions, excluding municipal obligations. Subject to revision as additional information becomes available. (2)          Not available from the same source. According to the statistical operating supplements published by the four largest monoline guarantors, those four companies insured directly or assumed, in the aggregate, approximately $163.3 billion of U.S. asset-backed par volume. Three of these companies disclose the non-U.S. component of their asset-backed business, which in aggregate was $39.1 billion in 2005. Consolidated Variable Interest Entities FSA Global is a Cayman Islands domiciled issuer of FSA-insured notes and other obligations sold in international markets that are generally referred to as “medium term notes.” FSA Global issues securities at the request of interested purchasers in a process known as “reverse inquiry,” which generally results in lower interest rates and borrowing costs than would apply to direct borrowings. FSA Global also issues securities in traditional private placements to institutional investors and to participants in lease financings in which Company affiliates may play a number of financing roles. As of December 31, 2005, the VIEs, including FSA Global, had $2.3 billion principal amount of outstanding notes, after elimination of intercompany transactions. FSA Global is managed as a “matched funded vehicle,” in which the proceeds from the sale of FSA Global notes are invested in obligations chosen to provide cash flows substantially matched to those of the notes (taking into account, in some cases, dedicated third party liquidity). This matched funding structure is designed to minimize the market risks borne by FSA Global and FSA. FSA Global raises funds that are invested with a view towards realizing the yield difference between the notes issued and the obligations purchased with the note proceeds. FSA Global generally raises funds that are U.S. dollar-denominated or converted into U.S. dollars at LIBOR-based floating borrowing rates, and invests them in FSA-insured obligations that: ·       are U.S. dollar-denominated or converted into U.S. dollars at LIBOR-based floating rates, ·       mature prior to the maturity of the related FSA Global notes, and ·       pay a higher interest rate than the interest rate on the related FSA Global notes. Financial Products Business The Company’s FP Segment provides GICs to municipalities and other market participants. FSA insures all GICs issued by the GIC Affiliates. The majority of municipal GICs insured by FSA relate to debt service reserve funds or construction funds that support municipal bond transactions. Each GIC entitles its holder to receive the return of the holder’s initial principal plus interest at a specified rate, and to withdraw principal from the GIC as permitted. Generally, a municipal bond trustee or issuer will acquire a municipal GIC in order to invest funds on deposit in a debt service reserve fund or  11    construction fund until it needs to use such funds to service debt or fund the payment of project expenses in accordance with the underlying bond documents. Non-municipal GICs insured by FSA include GICs acquired by issuers of credit linked notes and GICs acquired by FSA Global. The Company is exposed to risk associated with unexpected withdrawals on its FSA-insured GICs. Debt service reserve fund GICs may be drawn unexpectedly upon a payment default by the municipal issuer. Construction fund GICs may be drawn more quickly or more slowly than anticipated to pay project expenses. Structured finance GICs for credit-linked notes may be drawn unexpectedly upon certain credit events under the CDS related to such notes. In addition, most FSA-insured GICs allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below AA- by Standard & Poor’s Ratings Services (“S&P”) or Aa3 by Moody’s, unless the GIC provider posts collateral or otherwise enhances its credit. Some FSA-insured GICs also allow for withdrawal of GIC funds in the event of a downgrade of FSA, typically below A3 by Moody’s or A- by S&P, with no right of the GIC provider to avoid such withdrawal by posting collateral or otherwise enhancing its credit. The Company manages this risk through the maintenance of liquid collateral and liquidity agreements. The GIC Affiliates issue GICs and, on the same terms, lend the funds raised to FSAM. The funds are generally raised at (or converted by FSAM into) U.S. dollar LIBOR-based floating rate obligations. FSAM typically invests the funds in, or converts them into, U.S. dollar LIBOR-based floating rate investments. The investments are generally obligations that would qualify for FSA insurance from a credit perspective. The GIC Affiliates and FSAM generate their gross profits or losses from the difference between the rates at which the GIC Affiliates borrow the funds and the rates yielded by FSAM’s investments. These investments are owned, and all  related risk management functions are performed, by FSAM. Insurance in Force A summary of the Company’s par outstanding by type as of December 31, 2005 is as follows:             Par Outstanding                 Direct       Assumed       Total Gross       Ceded       Net                 (in millions)         Asset-backed(1)       $   139,567           $   999               $   140,566           $   30,143       $   110,423         Municipal       315,924           1,600               317,524           90,464       227,060         Total       $   455,491           $   2,599               $   458,090           $   120,607       $   337,483          (1)          Excludes direct par outstanding on intercompany insurance of $13,463 million relating to FSA-insured GICs issued by the GIC Affiliates. As of December 31, 2005, the weighted average life of the direct par insured on these policies was approximately four years for asset-backed and 13 years for municipal obligations. Municipal Obligations FSA’s insured portfolio of municipal obligations is divided into eight major categories, which include funded and synthetic obligations: Domestic General Obligation Bonds General obligation or full faith and credit bonds are issued by states, their political subdivisions and other municipal issuers, and are supported by the general obligation of the issuer to pay from available funds and by a pledge of the issuer to levy taxes according to value in an amount sufficient to provide for the full payment of the bonds. 12     Domestic Housing Revenue Bonds Housing revenue bonds include both multifamily and single family housing bonds, with multi-tiered security structures based on the underlying mortgages, reserve funds, and various other features such as Federal Housing Administration or private mortgage insurance, bank letters of credit, first loss guarantees and, in some cases, the general obligation of the issuing housing agency or a state’s “moral obligation” (that is, not a legally binding commitment) to make up deficiencies. Domestic Municipal Utility Revenue Bonds Municipal utility revenue bonds include obligations of all forms of municipal utilities, including electric, water and sewer utilities. Insurable utilities may be organized as municipal enterprise systems, authorities or joint-action agencies. Domestic Health Care Revenue Bonds Health care revenue bonds include bonds of state and local municipal authorities issued on a conduit basis on behalf of not-for-profit hospitals and hospital systems for refinancings and capital acquisitions and construction, payable from amounts derived under loan agreements and notes of such health care providers with such authorities. Domestic Tax-Supported (Non-General Obligation) Bonds Tax-supported (non-general obligation) bonds include a variety of bonds that, though not full faith and credit general obligations, are supported by a specific or discrete source of taxation of the issuer, and include tax-backed revenue bonds and general fund obligations of the issuer, such as lease revenue bonds. Tax-backed revenue bonds may be secured by a lien on pledged tax revenues, such as revenues from special taxes, including retail sales and gasoline taxes, or from tax increments (or tax allocations) generated by growth in property values within a district. FSA also insures bonds secured by special assessments levied against property owners, which benefit from covenants by the issuer to levy, collect and enforce collections and to foreclose on delinquent properties. Lease revenue bonds or certificates of participation (“COPs”) are usually general fund obligations subject to annual appropriation or abatement. The projects financed by lease revenue bonds or COPs are generally real property or equipment that, in the case of annual appropriation or abatement leases, FSA deems to serve an essential public purpose (e.g., schools, prisons, courts). Domestic Transportation Revenue Bonds Transportation revenue bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, tunnels, municipal parking facilities, toll roads and toll bridges. Other Domestic Municipal Bonds Other domestic municipal bonds insured by FSA include college and university (primarily public or state-supported) revenue bonds, moral obligation bonds, financings for stadiums, resource recovery bonds and debt issued, guaranteed or otherwise supported by domestic state or local governmental entities. International Municipal Obligations International municipal obligations include obligations of sovereign and sub-sovereign non-domestic municipal issuers, project finance transactions involving projects leased to or supported by payments from non-domestic governmental or quasi-governmental entities, toll road transactions supported by toll revenues, obligations arising under leases of equipment or facilities by non-domestic municipal obligors,  13    non-domestic municipal utility revenue bonds and other obligations having international aspects but otherwise within the municipal categories described above. Asset-Backed and Other Non-Municipal Obligations FSA’s insured portfolio of asset-backed and other non-municipal obligations is divided into five major categories, which are broadly based on the type of assets backing the insured obligations and include funded and synthetic obligations: Domestic Residential Mortgage Loans Obligations primarily backed by residential mortgage loans generally take the form of conventional pass-through certificates or pay-through debt securities, but also include other structured products. Residential mortgage loans backing these insured obligations include closed- and open-end first and second mortgage loans or home equity loans on one-to-four family residential properties, including condominiums and cooperative apartments. Domestic residential mortgage loan obligations insured by FSA have tended to be concentrated in the “sub-prime” sector, characterized by lower quality borrowers and higher levels of structural credit protection through subordination and/or excess spread. FSA also insures “net interest margin” (“NIM”) securities backed by the senior portion of residual cash flows from securitizations of domestic residential mortgage loans. FSA has generally declined participation in securitizations of so-called “high cost mortgage loans,” characterized by very high interest rates or “points and fees” and subject to restrictive federal and state regulations. Domestic Consumer Receivables Obligations primarily backed by consumer receivables include conventional pass-through and pay-through securities as well as more highly structured transactions. Consumer receivables backing these insured obligations include automobile loans, manufactured housing loans and credit card receivables. Consumer receivable transactions insured by FSA have tended to be concentrated in the sub-prime auto loan and credit card receivable sectors. Domestic Pooled Corporate Obligations Obligations primarily backed by pooled corporate obligations include funded and synthetic obligations collateralized by corporate debt securities or corporate loans and obligations backed by cash flow or market value of non-consumer indebtedness, and include CDOs, such as “collateralized bond obligations,” “collateralized loan obligations” and comparable risks under CDS obligations. Corporate obligations include corporate bonds, bank loan participations, trade receivables, franchise loans and equity securities. Some CDS obligations expose FSA to elements of market value risk arising from obligations to pay the difference between par and market value upon the occurrence of a payment default or other defined “credit events” specified in the CDS. FSA generally addresses these risks by requiring large deductibles as a condition to payment under pooled corporate CDS insured by FSA. Other Domestic Non-Municipal Obligations Other domestic non-municipal obligations include bonds or other securities backed by government securities, letters of credit, guarantees by other monoline insurers or repurchase agreements collateralized by government securities, securities backed by a combination of assets that include elements of more than one of the categories set forth above and unsecured corporate obligations satisfying FSA’s underwriting criteria. Other domestic non-municipal obligations insured by FSA also include first mortgage bond obligations of for-profit electric or water utilities providing retail, industrial and commercial service, sale-leaseback obligation bonds supported by such utilities and other obligations backed by investor-owned  14    utilities. These bonds are either secured by a mortgage on property owned by or leased to an investor-owned utility or have the benefit of a “negative pledge” ensuring that no other material creditors have priority claims to the utility assets. International Asset-Backed Obligations International asset-backed obligations include obligations of funded and synthetic CDOs, securitizations of perpetual floating rate notes of non-domestic banks, obligations of non-domestic investor-owned utilities and other obligations having international aspects but otherwise within the asset-backed categories described above. Insured Portfolio A summary of FSA’s insured portfolio as of December 31, 2005 is shown below. Exposure amounts are expressed net of reinsurance but do not distinguish between quota share, first loss or excess of loss reinsurance. Summary of Insured Portfolio As of December 31, 2005(1)             Number of   Issuers       Net Par   Amount   Outstanding       Net   Par and   Interest       Percent   of Net   Par and   Interest                 (dollars in millions)         Municipal   obligations                                                                 General obligation bonds           6,104               $   88,922           $   132,020           28   %         Housing revenue bonds           191               7,585           13,649           3             Municipal utility revenue bonds           1,079               37,245           60,350           13             Health care revenue bonds           222               11,789           21,483           4             Tax-supported (non-general obligation)   bonds           1,065               40,622           62,762           13             Transportation revenue bonds           122               14,695           26,201           5             Other domestic municipal bonds           725               13,955           21,540           5             International obligations           112               12,247           24,638           5             Total municipal obligations           9,620               227,060           362,643           76             Asset-backed obligations                                                                 Residential mortgages           237               $   18,401           $   20,202           4             Consumer receivables           50               8,366           8,862           2             Pooled corporate obligations           309               47,253           49,613           10             Other domestic asset-backed obligations           130               7,328           8,714           2             International obligations           108               29,075           30,151           6             Total asset-backed obligations           834               110,423           117,542           24             Total           10,454               $   337,483           $   480,185           100   %          (1)          Excludes intercompany insurance of $13,463 million in net par outstanding and $16,878 million in net par and interest outstanding relating to FSA-insured GICs issued by the GIC Affiliates. Obligation Type The table below sets forth the relative percentages of net par amount insured by obligation type during each of the last five years: 15    Annual New Business Insured by Obligation Type             Year Ended December 31,                 2005       2004       2003       2002       2001         Municipal   obligations                                                                                         General obligations bonds           28   %           19   %           27   %           19   %           12   %         Housing revenue bonds           1               6               3               2               1             Municipal utility revenue bonds           8               5               12               9               5             Health care revenue bonds           3               3               2               1               1             Tax-supported (non-general obligation)   bonds           11               2               14               8               5             Transportation revenue bonds           3               2               5               4               1             Other domestic municipal bonds           5               2               4               3               1             International obligations           5               2               2               2               1             Total municipal obligations           64               41               69               48               27             Asset-backed   and other non-municipal obligations                                                                                         Residential mortgages           9               28               7               9               16             Consumer receivables           5               2               6               10               12             Pooled corporate obligations           13               13               5               15               25             Other domestic non-municipal obligations(1)           1               8               2               1               1             International obligations           8               8               11               17               19             Total asset-backed obligations           36               59               31               52               73             Total           100   %           100   %           100   %           100   %           100   %          (1)          Excludes intercompany transactions of $6.3 billion in 2005, $2.7 billion in 2004, $3.6 billion in 2003, $2.0 billion in 2002 and $0.5 billion in 2001, relating to FSA-insured GICs issued by the GIC Affiliates. Terms to Maturity The table below sets forth the contractual terms to maturity of the Company’s policies as of December 31, 2005 and 2004: Contractual Terms to Maturity of Net Par of Insured Obligations(1)             As of December 31, 2005       As of December 31, 2004         Term to Maturity               Municipal       Asset-   Backed(2)       Municipal       Asset-   Backed(2)                 (in millions)         0 to 5 years       $   44,272       $   41,997       $   39,448       $   46,800         5 to 10 years       49,935       31,354       43,165       29,155         10 to 15 years       44,392       12,180       37,174       10,772         15 to 20 years       36,737       744       30,857       1,084         20 years and   above       51,724       24,148       44,748       34,539         Total       $   227,060       $   110,423       $   195,392       $   122,350                            (1)          Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties. The average expected maturities for asset-backed obligations are expected to be considerably shorter than the contractual maturities for such obligations. (2)          Excludes intercompany insurance of $13,463 million in 2005 and $7,143 million in 2004 relating to FSA-insured GICs issued by the GIC Affiliates. 16     Issue Size The tables below set forth the number of policies and net par outstanding as of December 31, 2005, based on the amount of original net par written: Municipal—Policy Count and Net Par Amount Outstanding     Original Net Par Amount               Number   of Policies       Net Par Amount   Outstanding                 (dollars in millions)         Less than $10   million           15,579               $   34,276             $10 to $50   million           5,475               64,748             $50 million to   $100 million           979               34,447             $100 million or   greater           851               93,589             Total           22,884               $   227,060               Asset-Backed—Policy Count and Net Par Amount Outstanding(1)     Original Net Par Amount               Number    of Policies       Net Par Amount   Outstanding                 (dollars in millions)         Less than $10   million           731               $   302             $10 to $50   million           641               5,254             $50 million to   $100 million           477               8,700             $100 million or   greater           1,001               96,167             Total           2,850               $   110,423                (1)          Excludes intercompany insurance of $13,463 million relating to FSA-insured GICs issued by the GIC Affiliates. 17    Geographic Concentration The Company seeks to maintain a diversified portfolio of insured municipal obligations designed to spread its risk across a number of geographic areas. The table below sets forth those jurisdictions in which municipalities issued an aggregate of 2% or more of the total net par amount outstanding of FSA-insured municipal securities: Municipal Insured Portfolio by Jurisdiction             As of December 31, 2005         Jurisdiction               Number   of Issuers       Net Par   Amount   Outstanding       Percent of Total   Municipal Net   Par Amount   Outstanding                 (dollars in millions)         California           985               $   30,159               13.3   %         New York           671               19,555               8.6             Texas           730               15,458               6.8             Pennsylvania           752               14,843               6.5             Florida           277               12,063               5.3             Illinois           653               11,255               5.0             New Jersey           584               10,459               4.6             Washington           328               8,289               3.6             Michigan           499               8,252               3.6             Massachusetts           206               6,309               2.8             Ohio           332               5,239               2.3             Wisconsin           437               4,938               2.2             Georgia           117               4,743               2.1             All other U.S.   jurisdictions           2,937               63,251               27.9             International           112               12,247               5.4             Total           9,620               $   227,060               100.0   %                              In its asset-backed business, the Company considers geographic concentration as a factor in underwriting insurance for securitizations of pools of assets, such as residential mortgage loans or consumer receivables. However, the geographic concentration of the underlying assets may change over the life of the policy. In addition, in writing insurance for other types of asset-backed obligations, such as securities primarily backed by government or corporate debt, geographic concentration is not considered a significant credit factor given other more relevant measures of diversification, such as issuer or industry diversification. 18    The Company’s revenues from external customers attributed to the United States and all foreign countries during each of the last three fiscal years is shown below: Total Revenues From External Customers             Year Ended December 31,                 2005       2004       2003                 (in thousands)         U.S.       $   941,496       $   1,095,914       $   864,752         International       39,739       52,355       32,926         Total revenues       $   981,235       $   1,148,269       $   897,678           For a discussion of risks related to the Company’s foreign operations, see “Item 1A. Risk Factors—The Company’s international operations expose it to less predictable credit and legal risks.” See Note 23 to the Consolidated Financial Statements in Item 8 for revenues from external customers, pre-tax earnings and total assets by segment. Issuer Concentration The Company has adopted underwriting and exposure management policies designed to limit the net par insured or net retained credit gap for any one credit. Credit gap is a concept employed by S&P to estimate the at-risk amount (worst-case risk) on an insured exposure. FSA has also established procedures to ensure compliance with regulatory single-risk limits applicable to bonds it has insured. In many cases, the Company uses reinsurance to limit net exposure to any one credit. As of December 31, 2005, the ten largest net insured municipal credits represented $9.6 billion, or 2.9%, of the total net par amount outstanding and the ten largest net insured asset-backed transactions represented $16.1 billion, or 4.8%, of the total net par amount outstanding. For purposes of the foregoing, different issues of asset-backed securities by the same sponsor have not been aggregated. However, the Company’s underwriting policies establish single risk guidelines applicable to asset-backed securities of the same sponsor. In addition, individual corporate names may appear in more than one FSA-insured CDO transaction, but such exposures are not aggregated for purposes of identifying the largest exposures. Instead, FSA addresses these risks by limiting its exposure to the CDO sector in the aggregate. In addition to the single risk limits established by its underwriting guidelines, the Company is subject to regulatory limits and rating agency guidelines on exposures to single credits. Credit Underwriting Guidelines, Standards and Procedures Financial Guaranty Business Financial guaranty insurance written by FSA generally relies on an assessment of the adequacy of various payment sources to meet debt service or other obligations in a specific transaction without regard to premiums paid or income from investment of premiums. FSA’s underwriting policy is to insure municipal and asset-backed obligations that it determines are investment grade without the benefit of FSA’s insurance. To this end, each policy FSA writes or reinsures is designed to satisfy the general underwriting guidelines and specific standards for particular types of obligations approved by its Board of Directors. In addition, the Company’s Board of Directors has established an Underwriting Committee that reviews completed transactions, generally on a quarterly basis, to ensure conformity with underwriting guidelines and standards. In addition, FSA’s underwriting policy allows for FSA to insure securities issued to refinance other securities insured by FSA as to which the issuer is or may be in default. 19     FSA’s underwriting guidelines for municipal obligations require that a transaction be rated investment grade by Moody’s or S&P or, in the alternative, that the credit quality of the obligor is considered by FSA to be the equivalent of investment grade. Where the municipal obligor is a governmental entity with taxing power or providing an essential public service paid by taxes, assessments or other charges, supplemental protections may be required if such taxes, assessments or other charges are not projected to provide sufficient debt service coverage. Where appropriate, the municipal obligor may be required to provide a rate covenant and a pledge of additional security (e.g., mortgages on real property, liens on equipment or revenue pledges) to secure the insured obligation. FSA’s underwriting guidelines for asset-backed obligations are premised on the concept of multiple layers of protection, and vary by obligation type in order to reflect different structures and types of credit support. FSA seeks to insure asset-backed obligations that generally provide for one or more forms of overcollateralization (such as excess collateral value, excess cash flow or “spread,” reserves or, in the case of CDS, a deductible) or third-party protection (such as bank letters of credit, guarantees, net worth maintenance agreements, indemnity agreements, CDS or reinsurance agreements). Asset-backed obligations insured by FSA often benefit from self-adjusting mechanisms, such as cash traps or accelerated amortization that take effect upon a failure to satisfy performance based triggers. Overcollateralization or third-party protection does not need to protect FSA against all risk of loss, but is generally intended to assume the primary risk of financial loss. Overcollateralization and third-party protection may not be required in transactions in which FSA is insuring the obligations of certain highly rated issuers that typically are regulated, have implied or explicit government support, or are short term, or in transactions in which FSA is insuring securities issued to refinance other securities insured by FSA as to which the issuer is or may be in default. FSA’s general policy has been to insure 100% of the principal, interest and other amounts due in respect of funded asset-backed obligations rather than providing partial or first-loss coverage sufficient to confer a Triple-A rating on the senior obligations. In the CDS sector, FSA often insures risks, and in the funded sector FSA sometimes insures securities, on a “compressed” or “mezzanine” basis in which the obligations insured by FSA are subordinate, in whole or in part, to more senior uninsured obligations. The rating agencies participate to varying degrees in the underwriting process. Most asset-backed obligations insured by FSA are reviewed prior to issuance by both S&P and Moody’s to evaluate the risk proposed to be insured. In the case of municipal obligations, prior rating agency review is a function of the type of insured obligation and the risk elements involved. The independent review of FSA’s underwriting practices performed by the rating agencies further strengthens the underwriting process. The Company’s Risk Management Committee reviews the Company’s insured portfolio on a periodic basis. The Risk Management Committee includes FSA’s Chief Risk Management Officer, Chief Domestic Underwriting Officer, Chief Municipal Underwriting Officer and Chief International Underwriting Officer, with FSA’s Chief Executive Officer, President, General Counsel and Chief Financial Officer as ex officio members. The underwriting process that implements the Company’s underwriting guidelines and standards is supported by FSA’s professional staff of analysts, underwriting officers, credit officers and attorneys. Moreover, the approval of senior management and designated senior underwriting officers is required for all transactions. Each underwriting group in the Financial Guaranty Group is responsible for confirming that each transaction proposed by the Financial Guaranty Group conforms to the underwriting guidelines and standards. This evaluation is reviewed by the chief underwriting officer for the particular sector. This review may take place while the transaction is in its formative stages, thus facilitating the introduction of further enhancements at a stage when the transaction is more receptive to change. 20    Final transaction approval is obtained from FSA’s Management Review Committee (the “MRC”) for asset-backed transactions and international transactions and from FSA’s Municipal Underwriting Committee (the “MUNC”) for domestic municipal transactions. Approval is usually based upon both a written and an oral presentation by the underwriting group to the respective committee. Following approval, the Chair of the applicable underwriting committee may approve minor transaction modifications. Major changes require the concurrence of the applicable underwriting committee. The MRC is comprised of FSA’s Chief Executive Officer, President, Chief Risk Management Officer, Chief Domestic Underwriting Officer, Chief International Underwriting Officer, General Counsel and Associate General Counsel for Asset-Backed Transactions. The Chief Executive Officer, President and General Counsel are not required to participate in MRC meetings for transactions meeting certain criteria. The MRC may delegate approval authority for certain highly rated asset-backed transactions that fall below established monetary thresholds. The MUNC is comprised of FSA’s Chief Executive Officer, President, Chief Municipal Underwriting Officer, a Municipal Underwriting Officer, Managing Director of Public Finance and Associate General Counsel for Municipal Transactions. The MUNC approval process generally requires approval by at least: ·       the Chief Executive Officer or President, ·       the Chief Municipal Underwriting Officer or Municipal Underwriting Officer, and ·       an Associate General Counsel for Municipal Transactions. Subject to applicable limits, municipal transactions satisfying credit and return requirements may be approved by a committee (the “Demi-MUNC”) comprised of at least two voting members, one of whom must be the Chief Municipal Underwriting Officer, Municipal Underwriting Officer or Managing Director for Municipal Operations, and any one of certain managing directors and directors designated by the MUNC. Financial Products Business The Company’s GIC Affiliates issue GICs and FSAM makes investments in accordance with the FP Segment’s underwriting guidelines. These underwriting guidelines require that each GIC and investment meet the funding strategy of the FP business. The funding strategy, in turn, reflects the Company’s short-term liquidity needs to meet withdrawals and purchase assets, the Company’s collateral posting obligations under collateralized GICs, the availability of attractive investments, the risk that actual GIC withdrawals may vary from expected withdrawals and other factors. FP’s underwriting guidelines also govern FSAM’s investment of funds raised from the issuance of GICs. In general, investments are obligations that would qualify for FSA insurance from a credit perspective, and must therefore be investment grade. The FP Segment manages its investment portfolio to maintain sufficient liquidity to address expected and unexpected GIC withdrawals and to maintain sufficient eligible collateral to support collateralized GICs. Final transaction approval for a GIC depends on the type and size of the GIC along with other criteria. FP’s underwriting guidelines require that the head of the FP Segment approve all GICs and specify whether approval from FSA’s Chief Executive Officer, President, Chief Risk Management Officer and/or other officers is also required. Final transaction approval for an investment by FSAM depends on the investment sector, credit rating, amount and other factors. The FP Segment’s underwriting guidelines require that the head of the FP Segment approve all investments and specify whether approvals from FSA’s Chief Executive Officer, President, Chief Risk Management Officer and/or other officers is also required. 21    Corporate Research FSA’s Corporate Research Department is comprised of a professional staff under the direction of the Chief Risk Management Officer. The Corporate Research Department is responsible for evaluating the credit of entities participating in or providing recourse on obligations insured by FSA. It also provides analysis of industry segments. Members of the Corporate Research Department generally report their findings directly to the appropriate underwriting committee in the context of transaction review and approval. Transaction Oversight and Transaction Services FSA’s Transaction Oversight Groups and its workout subsidiary TSC are independent of the analysts and credit officers involved in the underwriting process. The Municipal and Asset-Backed Transaction Oversight Groups are responsible for monitoring the performance of outstanding transactions. TSC, together with the Transaction Oversight Groups, is responsible for taking remedial actions for underperforming transactions as appropriate. The managing directors responsible for the transaction oversight and transaction services functions report to the Chief Risk Management Officer. The Underwriting Committee of the Board of Directors receives quarterly reports describing the changes in the overall insured portfolio during the quarter. The Transaction Oversight Groups review insured transactions to confirm compliance with transaction covenants, monitor credit and other developments affecting transaction participants and collateral, and together with TSC and the Risk Management Committee determine the steps, if any, required to protect the interests of FSA and the holders of FSA-insured obligations. Reviews of asset-backed transactions typically include an examination of reports provided by, and (as circumstances warrant) discussions with, issuers, servicers, trustees and other transaction participants. Reviews of asset-backed transactions often include servicer audits, site visits or evaluations by third-party appraisers, engineers or other experts retained by FSA. The Transaction Oversight Groups review transactions to determine the level of ongoing attention required. These judgments relate to current credit quality and other factors, including compliance with reporting or other requirements, legal or regulatory actions involving transaction participants and liquidity or other concerns that may not have a direct bearing on credit quality. Transactions with the highest risk profile are generally subject to more intensive review and, if appropriate, remedial action. The Transaction Oversight Groups and TSC work together with the Legal Department and Corporate Research in monitoring these transactions, negotiating restructurings and pursuing appropriate legal remedies. The Company’s Transaction Oversight Groups categorize all credits by risk of loss to facilitate appropriate allocation of resources to loss mitigation efforts and to efficiently communicate the relative credit condition of any risk exposure, as well as the overall health of the insured portfolio. Each risk in the insured portfolio is designated one of five surveillance rating categories. Categories I and II represent fundamentally sound transactions requiring routine monitoring. Category III represents transactions with a material deterioration in asset performance, financial health of the issuer, or other factors, but for which losses are deemed unlikely. Active monitoring and intervention is employed for Category III transactions. Category IV reflects transactions demonstrating sufficient deterioration to indicate that material credit losses are possible even though not yet probable. Category IV is the equivalent of “watch list” by banking industry standards. Category V reflects transactions where losses are probable. This category includes (1) risks where claim payments have been made and where additional payments, net of recoveries, are expected, and (2) risks where claim payments are probable but none have yet been made. Category IV and Category V transactions are subject to intense monitoring and intervention. 22    The table below presents the gross and net par outstanding and the gross and net reserves for risks classified as described above, as of December 31, 2005 and 2004. Par Outstanding             As of December 31,                 2005       2004                 Gross       Net       Gross       Net                 (in millions)         Categories I and   II       $   450,967       $   331,821       $   426,142       $   310,431         Category III       6,244       4,900       7,213       6,384         Category IV       266       242       283       245         Category V no   claims       506       463       707       647         Category V with   claims       107       57       85       35         Total       $   458,090       $   337,483       $   434,430       $   317,742           Case Basis Loss Reserves             As of December 31,                 2005       2004                 Gross       Net       Gross       Net                 (in millions)         Category V no   claims       $   49.1       $   40.3       $   36.4       $   30.3         Category V with   claims       40.7       13.1       44.2       14.9         Total       $   89.8       $   53.4       $   80.6       $   45.2           The increase in Category V reserves with no claims in 2005 compared to 2004 was due primarily to deterioration of certain CDO risks and the reassumption of previously ceded business. Legal The Company’s Legal Department is comprised of a professional staff of attorneys and legal assistants under the direction of the General Counsel. The Company’s Legal Department is divided into five sectors:  asset-backed transactions, municipal transactions, financial products, regulatory/reinsurance/corporate and compliance. The Legal Department plays a major role in establishing and implementing legal requirements and procedures applicable to obligations insured by the Company. Members of the Legal Department serve on the MRC and MUNC, which provide final underwriting approval for transactions. An attorney in the Legal Department works together with his or her counterpart in the relevant financial guaranty group in determining the legal and credit elements of each obligation proposed for insurance and in overseeing the execution of approved transactions. Asset-backed obligations insured by the Company are ordinarily executed with the assistance of outside counsel working closely with the Legal Department. Municipal obligations insured by the Company are ordinarily executed without employment of outside counsel. The financial products attorneys in the Legal Department work together with their counterparts in the FP group in developing and overseeing the execution of approved financial products transactions. The Legal Department works closely with the Transaction Oversight Groups and TSC in addressing legal issues, rights and remedies, as well as proposed amendments, waivers and consents, in connection with obligations insured by the Company. The Legal Department is also responsible for domestic and international regulatory compliance, reinsurance, secondary market transactions, litigation and other matters. The Chief Compliance Officer is a member of the Legal Department, and provides quarterly compliance activity reports to the Company’s Management Committee and the Audit Committee of the Board of Directors of the Company. 23    Competition and Industry Concentration FSA faces competition from both other providers of and alternatives to third-party credit enhancement. Most securities are sold without third-party credit enhancement. Accordingly, each transaction FSA proposes to insure must generally compete against an alternative execution that does not employ third-party credit enhancement. FSA faces competition from other Triple-A rated monoline financial guaranty insurers, primarily Ambac Assurance Corp. (“Ambac”), Financial Guaranty Insurance Company (“FGIC”), MBIA Insurance Corp. (“MBIA”), XL Capital Assurance Inc. and CIFG Guaranty. Competition is largely based on premium rates, capacity, underwriting requirements and trading levels. New entrants to the market provide increasing competition to more established market participants such as FSA as they attempt to grow their market share. Assured Guaranty Corp. and Radian Asset Assurance Inc., two market participants previously engaged primarily in reinsurance, either directly or through affiliates, recently increased their focus on the primary financial guaranty insurance market. The Company understands that other parties are considering establishing new financial guaranty insurers that may compete with it. Entry requirements include: ·       assembling the group of experts required to operate a financial guaranty insurance business, ·       establishing claims-paying ability ratings with the credit rating agencies, ·       complying with substantial capital requirements, ·       developing name recognition and market acceptance with issuers, investment bankers and investors, and ·       organizing a monoline insurance company and obtaining insurance licenses to do business in the applicable jurisdictions. Traditional credit enhancers such as bank letter of credit providers and mortgage pool insurers provide competition to FSA as providers of credit enhancement for asset-backed obligations. Actions by securities rating agencies in recent years have significantly reduced the number of Triple-A rated financial institutions that can offer a product directly competitive with FSA’s Triple-A guaranty, and risk-based capital guidelines applicable to banks have generally increased costs associated with letters of credit that compete directly with financial guaranty insurance. Nonetheless, bank sponsored commercial paper conduits, bank letter of credit providers and other credit enhancement, such as cash collateral accounts provided by banks, continue to provide significant competition to FSA. In addition, CDS, credit-linked notes and other synthetic products provide coverage directly competitive with financial guaranty insurance, and expand the universe of participants in the financial risk market. Bank affiliates may participate in the U.S. insurance business, including the financial guaranty insurance business. Government sponsored entities, including Fannie Mae and Freddie Mac, compete with the monoline financial guaranty insurers, on a limited basis, in the mortgage-backed and multifamily sectors. Expansion of the business franchises by government sponsored entities, as well as potential new entrants into the financial guaranty sector such as Federal Home Loan Banks and state pension funds, present competitive challenges to private sector participants such as FSA. Insurance law generally restricts multiline insurance companies, such as large property/casualty insurers and life insurers, from engaging in the financial guaranty insurance business other than through separately capitalized affiliates. Set forth below are FSA’s aggregate gross insurance in force, net insurance in force, qualified statutory capital and capital ratio (represented by the ratio of its net insurance in force to qualified statutory capital) and the average industry capital ratio at the dates indicated. FSA’s net insurance in force is the outstanding principal, interest and other amounts payable over the remaining life of all obligations insured by FSA, net of ceded reinsurance and refunded bonds secured by U.S. government securities held in escrow or other qualifying collateral. Qualified statutory capital, determined in accordance with  24    statutory accounting practices, is the aggregate of policyholders’ surplus and contingency reserves calculated in accordance with statutory accounting practices. Net insurance data does not distinguish between quota share reinsurance and first-loss reinsurance. In light of FSA’s use of first-loss reinsurance in the project finance and, to a lesser extent, asset-backed sectors, the data below tends to overstate FSA’s risk leverage in comparison with its industry counterparts. Conversely, FSA also insures mezzanine risks and obtains excess-of-loss credit protection in CDS transactions, which reduces FSA’s reported risk leverage. The statutory capital ratio does not reflect the underlying credit quality of the insurance in force, which diminishes the comparative value of the disclosure. Specifically, the credit quality of FSA’s insured portfolio as measured by S&P and Moody’s is generally higher than most of FSA’s industry peers, although FSA’s ratio of net debt service to statutory capital is also generally higher than most of FSA’s industry peers.           As of December 31,                 2005       2004       2003                 (dollars in millions)         Financial guaranty primary   insurers, excluding FSA(1)                                 Capital ratio       141:1       147:1       145:1         FSA(2)                                 Gross insurance in force       $   686,134       $   633,037       $   565,371         Net insurance in force       497,624       454,359       409,476         Qualified statutory   capital       2,418       2,281       2,104         Capital ratio       206:1       199:1       195:1                        (1)          Financial guaranty primary insurers for which data is included in this table are Ambac, FGIC and MBIA. Information relating to the financial guaranty primary insurers is derived from data from statutory accounting financial information publicly available from each insurer as of December 31, 2005, 2004 and 2003. (2)          Includes gross and net insurance in force relating to FSA-insured GICs issued by the GIC Affiliates of $16,878 million for 2005, $8,753 million for 2004, and $5,708 million for 2003. In December 2004, FSA obtained CDS protection on an excess of loss basis (exceeding very large deductibles) on a number of FSA-insured synthetic CDO transactions shadow rated “super-Triple-A” at inception. As of December 31, 2005, the CDS provided approximately $13.1 billion of credit protection. Given the high credit quality of the risk transferred to the CDS provider, the main effect of this CDS was to improve FSA’s statutory capital ratios and increase FSA’s margin under regulatory risk limits on aggregate insured exposures. Reinsurance Reinsurance is the commitment by one insurance company, the “reinsurer,” to reimburse another insurance company, the “ceding company,” for a specified portion of the insurance risks underwritten by the ceding company in consideration for a portion of the premiums received. The ceding company typically but not always receives a ceding commission to cover the costs of business generation. Because the insured party contracts for coverage solely with the ceding company, the failure of the reinsurer to perform does not relieve the ceding company of its obligation to the insured party under the terms of the insurance contract. 25     As of December 31, 2005, FSA reinsured approximately 26% of its principal amount outstanding. FSA obtains reinsurance to increase its policy writing capacity, both on an aggregate-risk and a single-risk basis, to: ·       meet internal, rating agency and regulatory limits, ·       diversify risks, ·       reduce the need for additional capital, and ·       strengthen financial ratios. FSA’s reinsurance may be on a quota share, first loss, or excess of loss basis. Quota share reinsurance generally provides protection against a fixed specified percentage of all losses incurred by FSA. First loss reinsurance generally provides protection against a fixed specified percentage of losses incurred up to a specified limit. Excess of loss reinsurance generally provides protection against a fixed percentage of losses incurred to the extent that losses incurred exceed a specified limit. Reinsurance arrangements typically require FSA to retain a minimum portion of the risks reinsured. FSA arranges reinsurance on both a facultative (transaction-by-transaction) and treaty basis. In addition, FSA employs “automatic facultative” reinsurance that permits FSA to apply reinsurance to transactions it selects subject to certain limitations. Treaty reinsurance provides coverage for a portion of the exposure from all qualifying policies issued during the term of the treaty. The reinsurer’s participation in a treaty is either cancelable annually upon 90 days’ prior notice by either FSA or the reinsurer or has a one-year term. Treaties generally provide coverage for the full term of the policies reinsured during the annual treaty period, except that, upon a financial deterioration of the reinsurer and the occurrence of certain other events, FSA generally has the right to reassume all or a portion of the business reinsured. Reinsurance agreements may be subject to other termination conditions as required by applicable state law. Primary insurers, such as FSA, are required to fulfill their obligations to policyholders if reinsurers fail to meet their obligations. The financial condition of reinsurers is important to FSA, and FSA endeavors to place its reinsurance with financially strong reinsurers. FSA’s treaty reinsurers as of December 31, 2005 were Assured Guaranty Re International Ltd. (formerly ACE Capital Re International Ltd.), BluePoint Re, Limited, Mitsui Sumitomo Insurance Company, Limited, Radian Asset Reinsurance Inc. (successor to Radian Reinsurance Inc., formerly Enhance Reinsurance Company), RAM Reinsurance Co. Ltd., Swiss Reinsurance Company, Tokio Marine and XLFA. FSA also has reciprocal surplus share reinsurance treaties with Ambac and FGIC, which provide quota share reinsurance on transactions exceeding specified par amounts insured. Securities rating agencies allow FSA “credit” for reinsurance based on the reinsurer’s ratings. Generally, 95-100% credit is allowed for Triple-A reinsurance and 65-90% credit is allowed for Double-A reinsurance. In recent years, a number of FSA’s reinsurers have been downgraded from Triple-A to Double-A or lower by one or more rating agency. While ceding commissions or premium allocation adjustments may compensate in part for such downgrades, the effect of such downgrades, in general, is to decrease the financial benefits of using reinsurance under rating agency capital adequacy models. In 2004, the insurance laws of the State of New York (the “New York Insurance Law”) were amended to allow financial guaranty insurers such as FSA to treat qualifying CDS from highly rated financial institutions as collateral for purposes of satisfying risk limits and certain reserve requirements. These amendments allow financial guaranty insurers to employ CDS as collateral for statutory accounting purposes, with the collateral having effects similar to reinsurance in reducing single and aggregate risks for statutory purposes. In December 2004, FSA obtained CDS protection on an excess of loss basis (exceeding very large deductibles) on a number of FSA-insured synthetic CDO transactions shadow rated  26    “super-Triple-A” at inception. As of December 31, 2005, the CDS provided approximately $13.1 billion of credit protection. Given the high credit quality of the risk transferred to the CDS provider, the main effects of this CDS were to improve FSA’s statutory capital ratios and increase FSA’s margin under regulatory risk limits on aggregate insured exposures. FSA, FSAIC and FSA International are party to a quota share reinsurance pooling agreement pursuant to which, after reinsurance cessions to other reinsurers, the FSA companies share in the net retained risk insured by each of these companies. Under the pooling agreement, FSA, FSAIC and FSA International share the net retained risk in proportion to their policyholders’ surplus and contingency reserves, or “statutory capital,” at the end of the prior calendar quarter. FSA-UK and FSA are party to a quota share and stop loss reinsurance agreement pursuant to which: ·       FSA-UK reinsures with FSA its retention under its policies after third party reinsurance based on an agreed-upon percentage that is substantially in proportion to the statutory capital of FSA-UK to the total statutory capital of FSA and its subsidiary insurers (including FSA-UK); and ·       subject to certain limits, FSA is required to make payments to FSA-UK when FSA-UK’s annual net incurred losses and expenses exceeds FSA-UK’s annual net earned premiums plus draws on FSA-UK’s equalization reserves to pay incurred losses. Under this agreement, FSA-UK ceded to FSA approximately 97.9% of its retention after third party reinsurance of its policies issued in 2005. Rating Agencies The value of FSA’s insurance product is generally a function of the “rating” applied to the obligations it insures. The financial strength of FSA and its insurance company subsidiaries is rated “Aaa” by Moody’s and “AAA” by S&P, Fitch Ratings and Rating and Investment Information, Inc. Such ratings reflect only the views of the respective rating agencies, are not recommendations to buy, sell or hold securities and are subject to revision or withdrawal at any time by such rating agencies. These rating agencies periodically review FSA’s business and financial condition, focusing on the insurer’s underwriting policies and procedures and the quality of the obligations insured, and publish their ratings and supporting analyses. Each rating agency performs periodic assessments of the credits insured by FSA, as well as the reinsurers and other providers of capital support to FSA, to confirm that FSA continues to satisfy such rating agency’s capital adequacy criteria necessary to maintain FSA’s Triple-A rating. FSA’s ability to compete with other Triple-A rated financial guarantors, and its results of operations and financial condition, would be materially adversely affected by any reduction in its ratings. Moody’s, S&P and Fitch apply their own capital adequacy models in assessing the financial strength of FSA. Financial factors considered by the rating agencies in assessing capital adequacy include: ·       capital charges or other assessments of credit risks for FSA’s insured portfolio, including the degree of risk embedded in FSA-insured GICs; ·       the quality of FSA’s assets and other investments (the “Investment Portfolio”); ·       the credit quality of FSA’s reinsurers and the type of reinsurance provided thereby; ·       credit lines and other capital support arrangements (“soft capital”); ·       premium revenues expected to be generated from outstanding policies; and ·       anticipated future new business originations and anticipated future losses. Given the importance of its ratings to its on-going business, FSA’s underwriting process generally includes an analysis of the impact on rating agency capital adequacy determinations in addition to other  27    measures of creditworthiness. Reference is made to the published reports of Moody’s, S&P and Fitch Ratings regarding the Company, capital adequacy models, the bond insurance business in general and FSA’s standing relative to its industry peers on the basis of capital adequacy and profitability. Insurance Regulatory Matters General FSA is licensed to engage in insurance business in all 50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands. FSA is subject to the New York Insurance Law and is also subject to the insurance laws of the other states in which it is licensed to transact insurance business. FSAIC is an Oklahoma domiciled insurance company also licensed in New York and subject to the New York Insurance Law. FSA and its domestic insurance company subsidiary are required to file quarterly and annual statutory financial statements in each jurisdiction in which they are licensed, and are subject to statutory restrictions concerning the types and quality of investments and the filing and use of policy forms and premium rates. FSA’s accounts and operations are subject to periodic examination by the Superintendent of Insurance of the State of New York (the “New York Superintendent”) and other state insurance regulatory authorities. The last completed examination was conducted in 2004 for the three-year period ended December 31, 2002. FSA International is a Bermuda domiciled insurance company subject to applicable requirements of Bermuda law. FSA International maintains its principal executive offices in Hamilton, Bermuda. FSA International does not intend to transact business or establish a permanent place of business in the United States or Europe. FSA-UK is a United Kingdom domiciled insurance company subject to applicable requirements of English law. FSA-UK maintains its principal executive offices in London, England. Pursuant to European Union Directives, FSA-UK is generally authorized to write business out of its London office in other member countries of the European Union subject to the satisfaction of perfunctory registration requirements. FSA has a Singapore branch authorized to transact insurance business in Singapore and subject to regulation by Singapore authorities. Domestic Insurance Holding Company Laws The Company and its domestic insurance company subsidiaries (FSA and FSAIC) are subject to regulation under insurance holding company statutes of their jurisdiction of domicile (New York and Oklahoma, respectively), as well as other jurisdictions where these insurers are licensed to do insurance business. The requirements of holding company statutes vary from jurisdiction to jurisdiction but generally require insurance holding companies and their insurance company subsidiaries to register and file certain reports describing, among other information, their capital structure, ownership and financial condition. The holding company statutes also require prior approval of changes in control, certain dividends and other intercorporate transfers of assets and transactions between insurance companies and their affiliates. The holding company statutes generally require that all transactions with affiliates be fair and reasonable and that those exceeding specified limits require prior notice to or approval by insurance regulators. Under the insurance holding company laws in effect in New York and Oklahoma, any acquisition of control of the Company, and thereby indirect control of FSA and FSAIC, requires the prior approval of the New York Superintendent and the Oklahoma Insurance Commissioner. “Control” is defined as the direct or indirect power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract or otherwise. Any purchaser of 10% or more of the outstanding voting securities of a corporation is presumed to have acquired control of that corporation and its subsidiaries, although the insurance regulator may find that “control” in fact does or does not exist when a person owns or controls either a lesser or greater amount of voting securities. 28    New York Financial Guaranty Insurance Law Article 69 of the New York Insurance Law (“Article 69”), a comprehensive financial guaranty insurance statute, governs all financial guaranty insurers licensed to do business in New York, including FSA. This statute limits the business of financial guaranty insurers to financial guaranty insurance and related lines (such as surety). Article 69 requires that financial guaranty insurers maintain a special statutory accounting reserve called the “contingency reserve” to protect policyholders against the impact of excessive losses occurring during adverse economic cycles. Article 69 requires a financial guaranty insurer to provide a contingency reserve: ·       with respect to policies written prior to July 1, 1989 in an amount equal to 50% of earned premiums; and ·       with respect to policies written on and after July 1, 1989, quarterly on a pro rata basis over a period of 20 years for municipal bonds and 15 years for all other obligations, in an amount equal to the greater of 50% of premiums written for the relevant category of insurance or a percentage of the principal guaranteed, varying from 0.55% to 2.50%, depending on the type of obligation guaranteed, until the contingency reserve amount for the category equals the applicable percentage of net unpaid principal. This reserve must be maintained for the periods specified above, except that reductions by the insurer may be permitted under specified circumstances in the event that actual loss experience exceeds certain thresholds or if the reserve accumulated is deemed excessive in relation to the insurer’s outstanding insured obligations. FSA has in the past sought and obtained releases of excessive contingency reserves from the New York Insurance Department. Financial guaranty insurers are also required to maintain reserves for losses and loss adjustment expenses on a case-by-case basis and reserves against unearned premiums. Article 69 establishes single risk limits for financial guaranty insurers applicable to all obligations issued by a single entity and backed by a single revenue source. For example, under the limit applicable to qualifying asset-backed securities, the lesser of: ·       the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, or ·       the insured unpaid principal (reduced by the extent to which the unpaid principal of the supporting assets exceeds the insured unpaid principal) divided by nine, net of qualifying reinsurance and collateral may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserves, subject to certain conditions. Under the limit applicable to municipal obligations, the insured average annual debt service for a single risk, net of qualifying reinsurance and collateral, may not exceed 10% of the sum of the insurer’s policyholders’ surplus and contingency reserves. In addition, insured principal of municipal obligations attributable to any single risk, net of qualifying reinsurance and collateral, is limited to 75% of the insurer’s policyholders’ surplus and contingency reserves. Single risk limits are also specified for other categories of insured obligations, and generally are more restrictive than those listed for asset-backed or municipal obligations. Article 69 also establishes aggregate risk limits on the basis of aggregate net liability insured as compared to statutory capital. “Aggregate net liability” is defined as outstanding principal and interest of guaranteed obligations insured, net of qualifying reinsurance and collateral. Under these limits,  29    policyholders’ surplus and contingency reserves must not be less than a percentage of aggregate net liability equal to the sum of various percentages of aggregate net liability for various categories of specified obligations. The percentage varies from 0.33% for certain municipal obligations to 4% for certain non-investment grade obligations. Dividend Restrictions FSA’s ability to pay dividends is dependent on FSA’s financial condition, results of operations, cash requirements, rating agency confirmation of non-impairment of FSA’s ratings and other related factors, and is also subject to restrictions contained in the New York Insurance Law and other states. Under New York Insurance Law, FSA may pay dividends out of statutory earned surplus, provided that, together with all dividends declared or distributed by FSA during the preceding 12 months, the dividends do not exceed the lesser of: ·       10% of policyholders’ surplus as of its last statement filed with the New York Superintendent; or ·       adjusted net investment income during this period. Based on FSA’s statutory statements for 2005, the maximum amount available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2005 was approximately $153.8 million. Financial Guaranty Insurance Regulation in Other Jurisdictions FSA is subject to laws and regulations of jurisdictions other than the State of New York concerning the transaction of financial guaranty insurance. The laws and regulations of these other jurisdictions are generally not more stringent in any material respect than the New York Insurance Law. The Bermuda Ministry of Finance regulates FSA International. The United Kingdom Financial Services Authority regulates FSA-UK. Pursuant to European Union Directives, FSA-UK has been authorized to provide financial guaranty insurance for transactions in numerous European countries from its home office in the United Kingdom. FSA has received a determination from the Australian Insurance and Superannuation Commissioner that the financial guaranties issued by FSA with respect to Australian transactions do not constitute insurance for which a license is required. The Monetary Authority of Singapore regulates activities of FSA’s Singapore branch. FSA is in the process of seeking a branch license in Japan. U.S. Bank Holding Company Act Dexia indirectly owns approximately 99% of the Company’s common stock. Because Dexia has a non-U.S. bank subsidiary with a branch in the U.S., Dexia and all of its subsidiaries, including the Company and its subsidiaries, are subject to the U.S. Bank Holding Company Act (the “BHC Act”). In general, the BHC Act restricts the activities of banking organizations and their affiliates to the ownership and operation of banks and to other activities that are “closely related to banking” as determined by the Board of Governors of the Federal Reserve System. Insurance activities such as those conducted by certain of the Company’s subsidiaries are generally not permissible under this restriction. Under the BHC Act, however, an organization that qualifies as a “financial holding company” is permitted to engage in a broader range of permissible “financial activities.” “Financial activities” include insurance underwriting and agency activities as well as merchant banking. For Dexia to qualify as a “financial holding company,” it and its non-U.S. bank subsidiary with a branch in the U.S. must be both: ·       “well-capitalized,” which requires a Tier I capital to risk-based assets ratio of at least 6% and a total capital to risk-based assets ratio of at least 10%, as calculated under home country standards (Tier I, or core, capital includes equity capital less certain intangibles), and 30    ·       “well-managed,” which requires a composite U.S. banking office examination rating by the relevant U.S. bank regulator of at least “satisfactory.” Dexia holds its investment in, and operates, the Company and its subsidiaries under the “financial activities” authorization permitted to “financial holding companies.”  If Dexia does not continue to meet the requirements for qualifying as a “financial holding company,” it may lose its ability to hold its investment in, or operate, the Company and its subsidiaries. Investments In addition to its insurance company Investment Portfolio, the Company maintains investments from proceeds of FSA-insured GICs (the “FP Investment Portfolio”), the portfolio of securities owned by the VIEs (the “VIE Portfolio”) and assets acquired from refinancing transactions. As of December 31, 2005, the Company also had investments in strategic partners, including: ·       XLFA; and ·       TheDebtCenter, L.L.C., which operates TheMuniCenter, L.L.C., an online exchange for municipal bonds. On October 4, 2005, the Company sold its investment in SPS Holding Corp. (“SPS”) (formerly Fairbanks Capital Holding Corp.), a residential mortgage loan servicer, to an unaffiliated third party. For its interest in SPS, the Company was paid $42.9 million in cash and expects to receive additional amounts, from time to time through March 31, 2008, out of income earned by SPS through December 31, 2007 from certain of its mortgage servicing activities. Under the sale documents, the subsidiary of the Company which owned the SPS investment made representations and warranties to, and undertook specified indemnification obligations for the benefit of, the purchaser. Investments Insured by the Company Both the Investment Portfolio and the FP Investment Portfolio include fixed income investments that are insured by FSA (“FSA-Insured Investments”).  The staff of the Securities and Exchange Commission (the “SEC”) is currently reviewing the accounting treatment of financial guaranty industry participants’ investments in securities insured by themselves or their affiliates, including the Company’s investments in FSA-Insured Investments. At December 31, 2005, the Investment Portfolio included $319.0 million of FSA-Insured Investments and the FP Investment Portfolio included $834.3 million of FSA-Insured Investments, measured at fair value, in each case representing approximately 7.0% of the relevant portfolio. The Company, like its industry peers, records these investments as available-for-sale securities and carries them at fair value, which includes the effect of the embedded FSA guaranty. The Company’s accounting treatment of the FSA-Insured Investments is based on Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” which requires that investment securities be carried at fair value, applying quoted prices where available. Quoted prices reflect the value of the embedded FSA insurance policy and related Triple-A rating. In 2005, the Company and other financial guaranty industry participants received written comments from the SEC staff regarding the proper accounting treatment for investments held by such companies that are also guaranteed by themselves or their affiliates, as is the case with the FSA-Insured Investments. Recent discussions with the SEC staff suggest that the staff’s tentative view of the appropriate accounting for FSA-Insured Investments is to extinguish a portion of the contingent guarantee obligation related to the amount held in its investment portfolio. The Company cannot predict how the SEC staff will resolve this issue or the resulting effect on its financial statements. The Company intends to continue to apply its current methodology until the issue is  31    resolved. There can be no certainty, however, that the SEC will not require the Company to modify its methodology, either on a going-forward basis or for prior periods. Investment Portfolio Management’s primary objective in managing the Investment Portfolio is to generate an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity, subject to rating agency capital adequacy criteria that reduce credit for investments based on their ratings to the extent rated less than Triple-A. The Investment Portfolio is managed by unaffiliated professional investment managers and the Company’s affiliate FSA Portfolio Management, which manages the majority of the municipal portfolio. The investment management function is overseen by the Investment Committee established by the Company’s Board of Directors. To accomplish its objectives, the Company has established guidelines for eligible fixed income investments by FSA, requiring that at least 95% of such investments be rated at least Single-A at acquisition and the overall portfolio be rated Double-A on average. Fixed income investments falling below the minimum quality level are disposed of at such time as management deems appropriate. For liquidity purposes, the Company’s policy is to invest primarily in readily marketable investments with no legal or contractual restrictions on resale. Eligible fixed income investments include U.S. Treasury and agency obligations, corporate bonds, tax-exempt bonds, asset-backed securities and mortgage-backed securities. In applying its investment guidelines, the Company uses the published rating for FSA-Insured Investments, rather than the rating that such securities would have without giving effect to the FSA guaranty, referred to as the “shadow rating.”  The Company’s current investment strategy is to invest in quality, readily marketable instruments of intermediate average duration so as to generate stable investment earnings with minimal market value or credit risk. The weighted average maturity of the fixed income securities in the Investment Portfolio as of December 31, 2005 was approximately 12 years. The Company’s investment in XLFA is included in the Investment Portfolio. 32     The following tables set forth certain information concerning the Company’s Investment Portfolio: Investment Portfolio by Rating As of December 31, 2005(1)(3)     Rating               Percent of   Investment   Portfolio         AAA(2)           78.6   %         AA           17.4             A            4.0             Total           100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available as of December 31, 2005. (2)          Includes U.S. Treasury obligations, which comprised 4.1% of the portfolio as of December 31, 2005. (3)          6.8% of the Investment Portfolio was rated Triple-A by virtue of insurance provided by FSA. Over 95% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Double-A range. Summary of Investments             As of December 31,                 2005       2004         Investment Category               Amortized   Cost       Weighted   Average   Yield(1)       Amortized   Cost       Weighted   Average   Yield(1)                 (dollars in thousands)         Long term investments:                                                         Taxable bonds       $   788,298           4.61   %       $   804,942           4.77   %         Tax-exempt bonds       3,431,046           4.77           3,058,967           4.75             Total long-term investments       4,219,344           4.74           3,863,909           4.75             Short-term   investments       182,645           2.81           119,746           2.07             Total fixed income investments       4,401,989           4.66           3,983,655           4.72             Equity   investments       54,370                       54,300                         Total investments       $   4,456,359                       $   4,037,955                                              (1)          Yields are stated on a pre-tax basis. 33    Investment Portfolio by Security Type             As of December 31,                 2005       2004         Investment Category               Amortized   Cost       Weighted   Average   Yield(1)       Amortized   Cost       Weighted   Average   Yield(1)                 (dollars in thousands)         U.S. government   and agency securities       $   195,495           4.49   %       $   164,312           4.30   %         Mortgage-backed   securities       250,001           5.24           220,202           5.31             Municipal bonds       3,431,046           4.77           3,058,967           4.75             Asset-backed   securities       40,216           3.84           56,843           3.23             Corporate   securities       186,369           4.66           237,486           4.81             Foreign   securities       116,217           3.62           126,099           5.06             Total long-term   investments       4,219,344           4.74           3,863,909           4.75             Short-term   investments       182,645           2.81           119,746           2.07             Total fixed income investments       4,401,989           4.66           3,983,655           4.72             Equity   investments       54,370                       54,300                         Total investments       $   4,456,359                       $   4,037,955                                              (1)          Yields are stated on a pre-tax basis. Distribution of Investments by Contractual Maturity             As of December 31,                 2005       2004         Investment Category               Amortized   Cost       Fair   Value       Amortized   Cost       Fair   Value                 (in thousands)         Due in one year   or less       $   274,955       $   275,017       $   174,831       $   174,872         Due after one   year through five years       1,188,212       1,248,314       552,672       558,554         Due after five   years through ten years       670,694       701,085       521,256       559,119         Due after ten   years       1,977,911       2,054,046       2,457,851       2,663,695         Mortgage-backed   securities       250,001       246,246       220,202       222,510         Asset-backed   securities       40,216       39,974       56,843       57,084         Total fixed   income investments       4,401,989       4,564,682       3,983,655       4,235,834         Equity   investments       54,370       54,370       54,300       54,300         Total investments       $   4,456,359       $   4,619,052       $   4,037,955       $   4,290,134                             Mortgage-Backed Securities Cost and Market Value by Investment Category             As of December 31, 2005                 Par Value       Amortized   Cost       Fair Value                 (in thousands)         Pass-through   securities U.S. Government agency       $   227,037       $   228,781       $   225,217         CMOs—U.S.   Government agency       4,590       4,762       4,637         CMOs—non-agency       16,191       16,458       16,392         Total mortgage-backed   securities       $   247,818       $   250,001       $   246,246           The Company’s investments in mortgage-backed securities primarily consisted of pass-through certificates and collateralized mortgage obligations (“CMOs”), which are backed by mortgage loans guaranteed or insured by agencies of, or sponsored by, the federal government. These securities are highly  34    liquid with readily determinable market prices. The Company also held, as of December 31, 2005, Triple-A rated CMOs which are not guaranteed by government agencies. Secondary market quotations are available for these securities, although they are not as liquid as government agency-backed securities. The CMOs held as of December 31, 2005 have stated maturities ranging from 1 to 30 years and expected average lives ranging from 1 to 15 years based on anticipated prepayments of principal. Mortgage-backed securities differ from traditional fixed income bonds because they are subject to prepayments at par value without penalty when the underlying mortgage loans are prepaid at the borrower’s option. Prepayment rates on mortgage-backed securities are influenced primarily by the general level of prevailing mortgage interest rates, with prepayments increasing when prevailing loan interest rates are lower than the rates on the underlying mortgage loans, and by the terms of the loans. When prepayments occur, the proceeds must be reinvested at then current market rates, which may be below the yield on the prepaid securities. FP Investment Portfolio The following tables set forth certain information concerning the FP Investment Portfolio: FP Investment Portfolio by Rating As of December 31, 2005(1)(2)     Rating               Percent of Investment   Portfolio         AAA           92.1   %         AA           6.5             A            1.4             Total           100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available as of December 31, 2005. (2)          7.0% of the FP Investment Portfolio was rated Triple-A by virtue of insurance provided by FSA. Over 90% of the FSA-Insured Investments were investment grade without giving effect to the FSA insurance. The average shadow rating of the FSA-Insured Investments was in the Single-A range. Summary of FP Investment Portfolio             December 31,                 2005       2004                 Amortized   Cost       Weighted   Average   Yield(1)       Amortized   Cost       Weighted   Average   Yield(1)                 (dollars in thousands)         FP Investment Portfolio:                                                         Taxable bonds       $   11,754,330           3.54   %       $   7,888,647           1.66   %         Short-term investments       1,015,509           3.31           268,125           1.43             Total investments       $   12,769,839           3.53           $   8,156,772           1.64              (1)          Yields are stated on a pre-tax basis. The weighted average yield presented is net of the effects of derivative instruments used to economically convert interest rates from fixed to floating rate. 35     FP Investment Portfolio by Security Type             As of December 31,                 2005       2004         Investment Category               Amortized   Cost       Weighted   Average   Yield(1)       Amortized   Cost       Weighted   Average   Yield(1)                 (dollars in thousands)         Mortgage-backed   securities       $   2,821,562           3.31   %       $   2,137,814           1.46   %         Municipal bonds       809,856           3.93           442,169           1.57             U.S. government   and agency securities       175,703           3.31           270,498           1.56             Asset-backed   and other securities       7,947,209           3.56           5,029,447           1.71             Corporate   securities       —           4.31           8,719           2.57             Total fixed maturities       11,754,330           3.54           7,888,647           1.66             Short-term   investments       1,015,509           3.31           268,125           1.43             Total investments       $   12,769,839           3.53           $   8,156,772           1.64                                  (1)          Yields are stated on a pre-tax basis. The weighted average yield presented is net of the effects of derivative instruments used to economically convert interest rates from fixed to floating rates. The weighted-average yield increased in 2005 due to rising interest rates, as the majority of the assets in the FP Investment Portfolio were floating rate assets. Distribution of FP Investments by Contractual Maturity             As of December 31, 2005         Investment Category               Amortized   Cost       Fair   Value                 (in thousands)         Due in one year   or less       $   1,037,032       $   1,037,032         Due after five   years through ten years       19,802       19,720         Due after ten   years       944,234       999,227         Mortgage-backed   securities       2,821,562       2,829,485         Asset-backed   and other securities       7,947,209       7,957,869         Total investments       $   12,769,839       $   12,843,333                       VIE Portfolio The Company’s management believes that the assets held by the VIEs, including those that are eliminated in consolidation, are beyond the reach of the Company and its creditors, even in bankruptcy or other receivership. All bonds in the VIE Portfolio are insured by FSA. The credit quality of the VIE Portfolio, without the benefit of FSA’s insurance, as of December 31, 2005 was as follows: VIE Portfolio by Rating(1)     Rating               Percent of Bonds         AAA           2.3   %         A           95.5             BB           2.2             Total           100.0   %          (1)          Ratings are based on the lower of Moody’s or S&P ratings available as of December 31, 2005. 36    The amortized cost and estimated fair value of bonds in the VIE Portfolio were as follows:             As of December 31, 2005                 Amortized Cost       Fair Value                 (in thousands)         Obligations of   U.S. states and political subdivisions           $   15,879           $   15,879         Corporate   securities           20,013           19,327         Foreign           8,995           9,841         Asset-backed   securities(1)           1,110,945           1,110,945         Short term   investments           2,674           2,674         Total           $   1,158,506           $   1,158,666                       As of December 31, 2004                 Amortized Cost       Fair Value                 (in thousands)         Obligations of   U.S. states and political subdivisions           $   16,007           $   16,007         Corporate   securities           156,030           157,990         Foreign           56,077           57,983         Asset-backed   securities(1)           1,114,375           1,114,375         Short term   investments           1,194           1,194         Total           $   1,343,683           $   1,347,549          (1)          Asset-backed securities consist of floating rate assets, which are valued using readily available quoted market prices or at amortized cost if there is no readily available valuation. Management believes that amortized cost closely approximates fair value for these securities. The amortized cost and fair value of bonds in the VIE Portfolio as of December 31, 2005, by contractual maturity, are shown below. Actual maturities could differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.             As of December 31, 2005                 Amortized Cost       Fair Value                 (in thousands)         Due in one year   or less           $   2,674           $   2,674         Due after one   year through five years           29,008           29,168         Due after five   years through ten years           —           —         Due after ten   years           15,879           15,879         Asset-backed   securities (stated maturities of 4 to 17 years)           1,110,945           1,110,945         Total           $   1,158,506           $   1,158,666           Employees As of December 31, 2005, the Company had 373 employees. None of its employees are covered by collective bargaining agreements. The Company considers its employee relations to be satisfactory. Available Information The Company makes available, free of charge through its website, http://www.fsa.com, its annual reports 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) and 15(d) of the Exchange Act as soon as reasonably practicable after the Company electronically files such materials with, or furnishes them to, the Securities and Exchange Commission. 37    Forward-Looking Statements The Company relies on the safe harbor for forward-looking statements provided by the Private Securities Litigation Reform Act of 1995. This safe harbor requires that the Company specify important factors that could cause actual results to differ materially from those contained in forward-looking statements made by or on behalf of the Company. Accordingly, forward-looking statements by the Company and its affiliates are qualified by reference to the following cautionary statements. In its filings with the SEC, reports to shareholders, press releases and other written and oral communications, the Company from time to time makes forward-looking statements. Such forward-looking statements include, but are not limited to: ·       projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts; ·       statements of plans, objectives or goals of the Company or its management, including those related to growth in adjusted book value or return on equity; and ·       expected losses on, and adequacy of loss reserves for, insured transactions. Words such as “believes,” “anticipates,” “expects,” “intends” and “plans” and similar expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. The Company cautions that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. These factors include: ·       the risks discussed in Item 1A of this report; ·       changes in capital requirements or other criteria of securities rating agencies applicable to financial guaranty insurers in general or to FSA specifically; ·       competitive forces, including the conduct of other financial guaranty insurers in general; ·       changes in domestic or foreign laws or regulations applicable to the Company, its competitors or its clients; ·       changes in accounting principles or practices that may result in a decline in securitization transactions or impact the Company’s reported financial results; ·       an economic downturn or other economic conditions (such as a rising interest rate environment) adversely affecting transactions insured by FSA or its Investment Portfolio; ·       inadequacy of reserves established by the Company for losses and loss adjustment expenses; ·       temporary or permanent disruptions in cash flow on FSA-insured structured transactions attributable to legal challenges to such structures; ·       downgrade or default of one or more of FSA’s reinsurers; ·       market conditions, including the credit quality and market pricing of securities issued; ·       capacity limitations that may impair investor appetite for FSA-insured obligations; ·       market spreads and pricing on insured CDS exposures, which may result in gain or loss due to mark-to-market accounting requirements; ·       prepayment speeds on FSA-insured asset-backed securities and other factors that may influence the amount of installment premiums paid to FSA; and ·       other factors, most of which are beyond the Company’s control. 38     The Company cautions that the foregoing list of important factors is not exhaustive. In any event, such forward-looking statements made by the Company speak only as of the date on which they are made, and the Company does not undertake any obligation to update or revise such statements as a result of new information, future events or otherwise. Item 1A.                Risk Factors. The information contained in this report may contain “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. See “Item 1.  Business—Forward-Looking Statements” for important factors that could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in forward-looking statements made by the Company. The Company’s actual future results may differ materially depending on a variety of factors including, but not limited to, the risks and uncertainties expressed below. Loss of FSA’s “Triple-A” ratings would impair its ability to originate new business. FSA’s ability to originate new insurance business is based upon the perceived financial strength of FSA’s insurance, which in turn is based in large part upon the financial strength ratings assigned to FSA by the major securities rating agencies. The rating agencies base their ratings upon a number of objective and subjective factors. Credit deterioration in FSA’s insured portfolio or changes to rating agency capital adequacy requirements could impair FSA’s ratings. For a discussion of other factors that might impair FSA’s ratings, see “Item 1. Business—Rating Agencies.”  Most of the risk factors mentioned below would be expected to be considered by the rating agencies in assessing FSA’s financial strength. The Company’s loss reserves may prove inadequate. The Company’s insurance policies guarantee financial performance of obligations over specified periods of time, in some cases over 30 years, and are generally non-cancellable. The Company projects expected deterioration and ultimate loss amounts based on historical experience in order to estimate probable loss. If an individual policy risk has a probable loss as of the balance sheet date, the Company establishes a case reserve. For the remaining policy risks in the portfolio, the Company establishes a non-specific reserve to account for inherent credit losses. The establishment of these reserves is a systematic process that considers quantitative and statistical information together with qualitative factors, resulting in management’s best estimate of inherent losses associated with providing credit protection at a given date. However, the process is inherently uncertain, and the Company cannot assure that its reserves will prove adequate. If losses in its insured portfolio materially exceed the Company’s loss reserves, it could have a material adverse effect on the financial ratings, results of operations and financial condition of the Company.  For additional discussion of the Company’s reserve methodologies, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Losses and Loss Adjustment Expenses.” The Company is exposed to large risks. FSA seeks to manage exposure to large single risks and concentrations of risks that may be correlated through credit and legal underwriting, reinsurance and other risk mitigation measures. In addition, the securities rating agencies and insurance regulations establish limits applicable to FSA on the size of risks and concentrations of risks that it may insure. Given FSA’s capital base and the quality of risks that it insures, FSA may and has insured individual municipal and asset-backed risks well in excess of $1 billion. Should FSA’s risk assessments prove inaccurate and should the limits applicable to FSA prove inadequate, FSA could be exposed to  larger than anticipated losses. While FSA has to date experienced catastrophic events (such as the terrorist attacks of September 11, 2001 and the 2005 hurricane season) without material loss, unexpected catastrophic events may have a material adverse effect upon FSA’s insured portfolio and/or its Investment Portfolio. 39    Increased competition could reduce the Company’s new business originations. The Company’s insurance company subsidiaries face competition from uninsured executions in the capital markets, other Triple-A rated monoline financial guaranty insurers, banks and other credit providers, including government-sponsored entities in the mortgage-backed and multifamily sectors. During recent years, competitive forces have put considerable downward pressure on premium levels that FSA has been able to obtain, and has led FSA to decline to participate in many transactions. Competitive pressures may lead a bond insurer to sacrifice adequate pricing or adequate credit protection in order to maintain market share. See “Item 1.  Business—Competition and Industry Concentration.” Decline in prevailing interest rates could reduce demand or premiums for financial guaranty insurance. Demand for financial guaranty insurance generally reflects prevailing interest-rate levels. When interest rates are lower, 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 may lead to a corresponding decrease in demand or premiums obtainable for financial guaranty insurance. Increase in prevailing interest rates would result in a decline in the market value of the Company’s Investment Portfolio. As of December 31, 2005, the Company’s Investment Portfolio was approximately $4.5 billion dollars, almost entirely invested in bonds, primarily municipal bonds. The Company’s investment strategy is to invest in highly rated marketable instruments of intermediate average duration so as to generate stable investment earnings with minimal market value or credit risk. Nonetheless, any increase in prevailing interest rates would reduce the market value of securities in the Company’s Investment Portfolio, which would in turn reduce the Company’s capital adequacy. Marking to market the Company’s insured CDS portfolio may subject the Company’s reported earnings to extreme volatility. The Company is required to mark to market certain derivatives, including FSA-insured CDS considered derivatives, under United States generally accepted accounting principles (“GAAP”). As a result of such treatment, and given the large principal balance of FSA’s insured CDS portfolio, small changes in the market pricing for insurance of CDS will generally result in recognition by the Company of material gains or losses, with material market price increases generally resulting in large reported losses under GAAP. In addition, any previously reported mark to market gains in respect of FSA’s insured portfolio would be expected to be reversed through the recognition of losses over the remaining terms of the insured risks. At December 31, 2005, the inception-to-date net gain on the Company’s insured CDS portfolio was $57.7 million. While management believes that reported mark to market gains or losses on insured CDS generally do not represent true economic gains or losses, certain constituents, including capital market participants, may rely upon reported GAAP results. As a result, the Company's access to capital markets might be impaired if its reporting earnings were considered unusually volatile. See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Operating Earnings and Adjusted Book Value.” Change in industry accounting practices could impair the Company’s reported financial results and impede its ability to do business. The SEC staff and the Financial Accounting Standards Board (the “FASB”) are evaluating various accounting standards applicable to financial guaranty insurers under GAAP, including accounting for claims liability recognition, premium recognition and amortization of deferred policy acquisition costs. The Company and its industry peers will be required to implement any changes to GAAP reporting requirements adopted by the SEC or the FASB. Any such changes may have an adverse effect on the  40    Company’s reported financial results. In addition, accounting changes may impact reported profitability of new business originations or their impact upon reported earnings during the terms of outstanding risks (so-called “earnings volatility”) and, as such, may influence the types and/or volume of business that management may chose to pursue. Change in applicable law could impede the Company’s ability to do business. The Company’s businesses are subject to direct and indirect regulation under, among other things, state insurance laws, federal securities law, the U.S. Bank Holding Company Act, tax law and legal precedents affecting municipal and asset-backed obligations, as well as applicable law in the other countries in which the Company operates. Future legislative, regulatory or judicial changes in the U.S. or abroad could adversely affect the Company’s business by, among other things, placing limits on the Company’s ability to carry out its non-insurance business, lowering applicable single or aggregate risk limits, increasing the level of supervision or regulation to which its operations may be subject, or creating restrictions that make the Company’s products less attractive to potential buyers. For additional information regarding the regulations to which the Company is subject, see “Item 1. Business—Insurance Regulatory Matters” and “—U.S. Bank Holding Company Act.” Change in management personnel or share ownership may have an adverse effect on the Company’s business. The Company’s senior management plays an active role in its underwriting and business decisions. In addition, FSA and Dexia have worked together on numerous new business opportunities, and such close cooperation may diminish were Dexia no longer an owner of the Company. Accordingly, a change in management or share ownership may have an adverse effect upon the Company’s business. Rating agency action may impede growth in the Company’s FP business. Moody’s is in the process of evaluating the conduct of non-core business activities by financial guaranty insurers. The Company’s FP Segment represents a growing and profitable segment of the Company’s operations. Any action by Moody’s or another securities rating agency to impede such business would have an adverse effect upon the Company. Losses may result from the ineffectiveness of hedges or unanticipated timing of withdrawals of funds in the Company’s FP Segment. The Company hedges interest-rate risks in its FP Segment by investing in floating-rate instruments and issuing floating-rate liabilities, or by employing derivative products to obtain the same economic result. Judgments are made in this process regarding the expected timing of withdrawals of funds under GICs and other financial products. The Company may be exposed to unexpected losses if its hedging strategy proves ineffective or its judgments prove inaccurate. The Company’s ability to make debt service payments on its outstanding debt is subject to its insurance company operations. Because it is a holding company, the registrant does not conduct operations or generate material income. Instead, the Company’s financial condition and results of operations, and thus its long-term ability to service its debt, will largely depend on its receipt of dividends from, or payment on surplus notes by, FSA. FSA’s ability to declare and pay dividends to the Company depends, among other factors, upon FSA’s financial condition, results of operations, cash requirements, and compliance with rating agency requirements for maintaining its Triple-A ratings, and is also subject to restrictions contained in the applicable insurance laws and regulations. Based on FSA’s statutory statements for 2005, the maximum amount available for payment of dividends by FSA without regulatory approval over the 12 months following December 31, 2005 is approximately $153.8 million. 41    Downgrade or default of one or more of the Company’s reinsurers could reduce the Company’s capital adequacy and return on equity. As of December 31, 2005, the Company had reinsured approximately 26% of its principal amount of insurance outstanding. In evaluating the credits insured by the Company, securities rating agencies allow “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. By itself, a downgrade of all reinsurers to Double-A would not impair the Company’s Triple-A ratings. However, it would reduce the “margin of safety” by which the Company would survive a theoretical catastrophic depression, and a more significant downgrade of the reinsurers could impair the Company’s Triple-A ratings. The Company could be required to raise additional capital to replace the lost reinsurance credit in order to meet capital adequacy 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 increased to compensate for such reduction. For further information regarding the Company’s use of reinsurance, see “Item 1. Business—Reinsurance.” The Company’s international operations expose it to less predictable credit and legal risks. The Company pursues opportunities in international markets and currently operates in various countries in Europe, the Pacific Rim and Latin America. 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. Item 1B.               Unresolved Staff Comments. Item 1B is not applicable to the Company, because the Company is not an accelerated filer or large accelerated filer, as defined in Rule 12b-2 of the Exchange Act, or a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. For a discussion of SEC staff comments, see “Item 1. Business—Investments—Investments Insured by the Company.” Item 2.                        Properties. The principal executive offices of the Company and FSA are located at 31 West 52nd Street, New York, New York, 10019, and consist of approximately 110,000 square feet of office space. FSA or its subsidiaries also maintain leased office space in San Francisco, Dallas, Hamilton (Bermuda), London (England), Madrid (Spain), Mexico City (Mexico), Paris (France), Singapore, Sydney (Australia) and Tokyo (Japan). The Company and its subsidiaries do not own any material real property. The Company’s telephone number at its principal executive offices is (212) 826-0100. Item 3.                        Legal Proceedings. In the ordinary course of business, the Company and certain subsidiaries are parties to litigation. The Company is not subject to any material pending legal proceedings. Item 4.                        Submission of Matters to a Vote of Security Holders. On February 16, 2006, the Company’s shareholders executed a Written Consent of Shareholders under which they unanimously approved amendments to the Company’s 2004 Equity Participation Plan. 42     PART II Item 5.                        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchaser of Equity Securities. On July 5, 2000, the Company completed a merger in which the Company became an indirect wholly owned subsidiary of Dexia, a Belgian corporation whose shares are traded in the Euronext Brussels and Euronext Paris markets as well as on the Luxembourg Stock Exchange. See “Item 1. Business—Organization.” As a consequence of the merger, there is no longer an established public trading market for the Company’s common stock, and bid quotations are not reported or otherwise available. As of March 15, 2006, the only holders of the Company’s common stock were Dexia Holdings, an affiliate of White Mountains (a major shareholder of the Company prior to the merger), and seven directors of the Company who own shares of the Company’s common stock or economic interests therein as described in “Item 11. Executive Compensation—Director Share Purchase Program.”  Dexia is required to repurchase the shares of the Company held by White Mountain’s affiliate in May 2006. The Company paid a dividend on its common stock of $0.17625 per share for each of the first two quarters of 2002, totaling $11.7 million in aggregate for 2002. During the third quarter of 2002, the Company determined that it would suspend payment of dividends. The Company resumed payment of regular quarterly dividends in May 2004, paying $22.9 million in aggregate for 2004 and $71.1 million in aggregate for 2005. In February 2006, the Board of Directors declared a regular quarterly dividend on the Company’s common stock of $0.97 per share, totaling $32.5 million in aggregate, to be paid on or before March 30, 2006. Information concerning restrictions on the payment of dividends is set forth in “Item 1. Business—Insurance Regulatory Matters—Dividend Restrictions.” Information about securities authorized for issuance under the Company’s equity compensation plans is set forth in “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters—Securities Available Under Equity Compensation Plans.” 43