SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------- FORM 8-K CURRENT REPORT Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 AUGUST 5, 1999 Date of Report (Date of earliest event reported) WHITE MOUNTAINS INSURANCE GROUP, INC. (Exact name of registrant as specified in its charter) DELAWARE 1-8993 94-2708455 (State or other jurisdiction of (Commission (I.R.S. Employer incorporation or organization) file number) Identification No.) 80 SOUTH MAIN STREET, HANOVER, NEW HAMPSHIRE 03755 (Address of principal executive offices) (603) 643-1567 (Registrant's telephone number, including area code)
ITEM 5. OTHER EVENTS. White Mountains Insurance Group, Inc. (the "Company") owns a minority interest in Financial Security Assurance Holdings Ltd. ("FSA"), which writes municipal and asset-backed securities credit enhancement insurance. The Company does not consolidate FSA into its financial statements due to its minority ownership position but did include the consolidated financial statements of FSA and the related report of independent accountants as Exhibit 99(b) to its Form 10-K for the year ended December 31, 1998. During a filing of a shelf registration by FSA in April 1999 and resulting discussions with the Securities and Exchange Commission, FSA revised its accounting with respect to a forward share purchase agreement with two financial institutions which it entered into in 1996. The effect of this change in accounting by FSA served to decrease its shareholders' equity by $7.3 million, $6.4 million and $2.7 million as of December 31, 1998, 1997 and 1996, respectively. The aggregate impact of the FSA restatement on the Company's December 31, 1998, December 31, 1997 and December 31, 1996 shareholders' equity is less than $1.0 million and, therefore, the Company does not expect to restate its historical results. The full impact of the FSA restatement has been reflected in the Company's June 30, 1999 financial statements. On August 5, 1999, FSA filed an amendment to its Form 10-K for the year ended December 31, 1998 to amend and restate its Form 10-K previously filed on March 25, 1999. Exhibit 99 to this Form 8-K filed herein contains the amended and restated consolidated financial statements of FSA and the related report of independent accountants. Exhibit 99 to this Form 8-K amends and supercedes Exhibit 99(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1998. ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS. (c) Exhibits. The following exhibits are filed herewith: Exhibit No. Description ----------- ----------- 23 Consent of PricewaterhouseCoopers LLP dated September 21,1999 99 Amended and restated 1998 consolidated financial statements of FSA and the related report of independent accountants
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. WHITE MOUNTAINS INSURANCE GROUP, INC. Dated: September 22, 1999 By: /s/ ------------- ------------------- Michael S. Paquette Senior Vice President and Controller
Exhibit 23 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the Registration Statements, as amended, pertaining to the Long-Term Incentive Plan (Form S-8, No. 33-5297), Medium-Term Notes Series A (Form S-3, No. 33-54006), Common Stock Warrants (Form S-3, No. 33-54749) and the Folksamerica Holding Company 401(K) Savings and Investment Plan (Form S-8, No. 333-82563) of White Mountain Insurance Group, Inc. (formerly "Fund American Enterprises Holdings, Inc.") of our report dated January 26, 1999, except for the restatements and reclassifications section in Note 2 as to which the date is August 4, 1999, with respect to the consolidated financial statements of Financial Security Assurance Holdings, Ltd. and Subsidiaries as of December 31, 1998 and 1997 and for each of the three years in the period ended December 31, 1998. PricewaterhouseCoopers LLP New York, New York September 21, 1999
Exhibit 99 REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Board of Directors of Financial Security Assurance Holdings Ltd.: In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, changes in shareholders' equity, and cash flows present fairly, in all material respects, the financial position of Financial Security Assurance Holdings Ltd. and Subsidiaries (the Company) at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. 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 generally accepted auditing standards, which 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 the opinion expressed above. As indicated in Note 2, the consolidated financial statements at December 31, 1998 and 1997 and for each of the three years in the period ended December 31, 1998 have been revised. /s/ PricewaterhouseCoopers LLP ------------------------------ PRICEWATERHOUSECOOPERS LLP New York, New York January 26, 1999, except for the restatements and reclassifications section in Note 2 as to which the date is August 4, 1999 1
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data) December 31, December 31, ASSETS 1998 1997 ----------- ----------- Bonds at market value (amortized cost of $1,655,042 and $1,230,479) $ 1,708,040 $ 1,268,158 Equity investments at market value (cost of $64,292 and $29,430) 68,243 30,539 Short-term investments 98,554 132,931 ----------- ----------- Total investments 1,874,837 1,431,628 Cash 3,490 12,475 Deferred acquisition costs 199,559 171,098 Prepaid reinsurance premiums 217,096 173,123 Reinsurance recoverable on unpaid losses 3,907 30,618 Receivable for securities sold 1,655 20,623 Investment in unconsolidated affiliates 29,496 -- Other assets 114,166 91,599 ----------- ----------- TOTAL ASSETS $ 2,444,206 $ 1,913,164 =========== =========== LIABILITIES AND MINORITY INTEREST, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY Deferred premium revenue $ 721,699 $ 595,196 Losses and loss adjustment expenses 63,947 75,417 Deferred federal income taxes 87,254 82,786 Ceded reinsurance balances payable 31,502 11,199 Payable for securities purchased 105,859 72,979 Notes payable 230,000 130,000 Minority interest 20,388 -- Accrued expenses and other liabilities 117,421 87,638 ----------- ----------- TOTAL LIABILITIES AND MINORITY INTEREST 1,378,070 1,055,215 ----------- ----------- COMMITMENTS AND CONTINGENCIES REDEEMABLE PREFERRED STOCK Redeemable preferred stock (3,000,000 shares authorized; 2,000,000 issued and outstanding; par value of $.01 per share) 20 20 Additional paid-in capital - preferred 680 680 ----------- ----------- 700 700 Common stock (50,000,000 shares authorized; 32,276,301 issued; par value of $.01 per share) 323 323 Additional paid-in capital - common 733,442 695,993 Accumulated other comprehensive income (net of deferred income tax provision of $20,288 and $13,575) 37,678 25,212 Accumulated earnings 325,150 222,571 Deferred equity compensation 43,946 26,181 Less treasury stock at cost (2,372,839 and 3,521,847 shares held) (75,103) (95,031) ----------- ----------- TOTAL SHAREHOLDERS' EQUITY 1,065,436 875,249 ----------- ----------- TOTAL LIABILITIES AND MINORITY INTEREST, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY $ 2,444,206 $ 1,931,164 =========== =========== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Each year has been revised. See Note 2 section entitled "Restatements and Reclassifications". 2
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except per share data) Year Ended December 31, ----------------------- REVENUES: 1998 1997 1996 --------- --------- --------- Net premiums written $ 219,853 $ 172,878 $ 121,000 Increase in deferred premium revenue (81,926) (63,367) (30,552) --------- --------- --------- Premiums earned 137,927 109,511 90,448 Net investment income 78,823 72,085 65,064 Net realized gains 20,890 11,522 3,189 Other income 474 9,303 297 --------- --------- --------- TOTAL REVENUES 238,114 202,421 158,998 --------- --------- --------- EXPENSES: Losses and loss adjustment expenses 3,949 9,156 6,874 Policy acquisition costs 35,439 27,962 23,829 Other operating expenses 40,631 35,755 22,732 --------- --------- --------- TOTAL EXPENSES 80,019 72,873 53,435 --------- --------- --------- Minority interest and equity in earnings of unconsolidated affiliates (844) -- -- --------- --------- --------- INCOME BEFORE INCOME TAXES 157,251 129,548 105,563 --------- --------- --------- Provision (benefit) for income taxes: Current 44,140 22,966 15,817 Deferred (2,245) 11,898 11,721 --------- --------- --------- Total provision 41,895 34,864 27,538 --------- --------- --------- NET INCOME 115,356 94,684 78,025 OTHER COMPREHENSIVE INCOME (LOSS), NET OF TAX: Unrealized gains (losses) on securities: Unrealized holding gains (losses) arising during period (net of deferred income tax provision (benefit) of $14,024, $12,701 and $(4,708)) 26,045 23,587 (8,744) Less: reclassification adjustment for gains included in net income (net of deferred income tax provision of $7,311, $4,033 and $1,116) (13,579) (7,489) (2,073) --------- --------- --------- Other comprehensive income (loss) 12,466 16,098 (10,817) --------- --------- --------- COMPREHENSIVE INCOME $ 127,822 $ 110,782 $ 67,208 ========= ========= ========= As based upon net income: Basic earnings per common share $ 3.96 $ 3.16 $ 2.55 ========= ========= ========= Diluted earnings per common share $ 3.77 $ 3.06 $ 2.52 ========= ========= ========= The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Each year has been revised. See Note 2 section entitled "Restatements and Reclassifications". 3
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (Dollars in thousands, except per share data) Additional Unrealized Paid-In Gain Deferred Common Capital - (Loss) on Accumulated Equity Treasury Stock Common Investments Earnings Compensation Stock Total ----- ------ ----------- -------- ------------ ----- ----- BALANCE, December 31, 1995 $323 $696,253 $19,931 $72,410 $ 6,504 $(18,174) $777,247 Net income for the year 78,025 78,025 Net change in accumulated comprehensive income (net of deferred income tax benefit of $5,823) (10,817) (10,817) Dividends paid on common stock ($0.35 per share) (10,536) (10,536) Deferred equity compensation 5,565 5,565 Purchase of 1,529,131 shares of common stock (40,611) (40,611) Other common stock transactions (1,135) (1,135) Adjustment to prior-year disposal of Subsidiary 87 87 ---- -------- ------- -------- ------- -------- ---------- BALANCE, December 31, 1996 323 695,118 9,114 139,986 12,069 (58,785) 797,825 Net income for the year 94,684 94,684 Net change in accumulated comprehensive income (net of deferred income taxes of $8,667) 16,098 16,098 Dividends paid on common stock ($0.405 per share) (12,099) (12,099) Deferred equity compensation 17,781 17,781 Deferred equity payout 187 (3,287) 56 (3,044) Purchase of 162,573 shares of common stock (5,434) (5,434) Issuance of 125,106 shares of treasury stock for options exercised 688 (382) 3,042 3,348 Forward share settlements with counterparties (33,910) (33,910) ---- -------- ------- -------- ------- -------- ---------- BALANCE, December 31, 1997 323 695,993 25,212 222,571 26,181 (95,031) 875,249 Net income for the year 115,356 115,356 Net change in accumulated comprehensive income (net of deferred income taxes of $6,713) 12,466 12,466 Dividends paid on common stock ($0.44 per share) (12,777) (12,777) Deferred equity compensation 23,970 23,970 Deferred equity payout 750 (6,371) 204 (5,417) Purchase of 496,940 shares of common stock (23,907) (23,907) Issuance of 1,632,653 shares of treasury stock for XL stock 36,721 43,279 80,000 Issuance of 13,295 shares of treasury stock for options exercised (22) 166 352 496 ---- -------- ------- -------- ------- -------- ---------- BALANCE, December 31, 1998 $323 $733,442 $37,678 $325,150 $43,946 $(75,103) $1,065,436 ==== ======== ======= ======== ======= ======== ========== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Each year has been revised. See Note 2 section entitled "Restatements and Reclassifications". 4
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) Year Ended December 31, ----------------------- 1998 1997 1996 ----------- ----------- ----------- Cash flows from operating activities: Premiums received, net $ 247,229 $ 171,145 $ 124,540 Policy acquisition and other operating expenses paid, net (53,306) (43,279) (32,266) Recoverable advances received (paid) 1,473 (7,629) 10,213 Losses and loss adjustment expenses recovered (paid) 10,989 (6,463) (15,473) Net investment income received 70,146 65,662 63,533 Federal income taxes paid (54,020) (19,797) (34,595) Interest paid (9,614) (5,158) (2,115) Other (1,623) (2,017) (4,253) ----------- ----------- ----------- Net cash provided by operating activities 211,274 152,464 109,584 ----------- ----------- ----------- Cash flows from investing activities: Proceeds from sales of bonds 1,908,098 1,074,658 1,117,473 Proceeds from sales of equity investments 33,613 3,568 -- Proceeds from maturities of bonds -- 32,468 2,965 Purchases of bonds (2,257,947) (1,229,612) (1,141,688) Purchases of equity investments (48,475) (24,662) (8,336) Net gain on sale of subsidiaries -- 7,986 -- Purchases of property and equipment (1,168) (3,097) (2,188) Net decrease (increase) in short-term investments 39,513 (55,551) (18,586) Other investments (14,610) -- -- ----------- ----------- ----------- Net cash used for investing activities (340,976) (194,242) (50,360) ----------- ----------- ----------- Cash flows from financing activities: Issuance of notes payable, net 96,850 125,905 -- Repayment of notes payable -- (30,000) -- Dividends paid (12,777) (12,099) (10,536) Treasury stock, net (23,686) (36,246) (41,660) Issuance of stock for acquisition of subsidiary (a) 60,000 -- -- Other 330 (1,453) -- ----------- ----------- ----------- Net cash provided by (used for) financing Activities 120,717 46,107 (52,196) ----------- ----------- ----------- Net increase (decrease) in cash (8,985) 4,329 7,028 Cash at beginning of year 12,475 8,146 1,118 ----------- ----------- ----------- Cash at end of year $ 3,490 $ 12,475 $ 8,146 =========== =========== =========== Continued (a) The Company exchanged $20,000 of its stock at fair market value for $20,000 of XL stock at fair market value. The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Each year has been revised. See Note 2 section entitled "Restatements and Reclassifications". 5
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED (Dollars in thousands) Year Ended December 31, -------------------------------- 1998 1997 1996 ---- ---- ---- Reconciliation of net income to net cash flows from operating activities: Net income $115,356 $ 94,684 $ 78,025 Increase in accrued investment income (3,613) (2,504) (578) Increase in deferred premium revenue and related foreign exchange adjustment 82,530 62,101 29,622 Increase in deferred acquisition costs (28,461) (24,865) (13,282) Increase (decrease) in current federal income taxes payable (1,674) 7,891 (7,368) Increase (decrease) in unpaid losses and loss adjustment expenses 15,240 2,596 (8,023) Increase in amounts withheld for others 82 133 52 Provision (benefit) for deferred income taxes (2,245) 15,170 11,721 Net realized gains on investments (20,890) (11,522) (3,189) Deferred equity compensation 17,765 14,299 5,565 Depreciation and accretion of bond discount (4,523) (2,802) (1,735) Minority interest and equity in earnings of unconsolidated affiliates 844 -- -- Net gain on sale of subsidiaries -- (7,986) -- Change in other assets and liabilities 40,863 5,269 18,774 -------- -------- -------- Cash provided by operating activities $211,274 $152,464 $109,584 ======== ======== ======== The accompanying Notes to Consolidated Financial Statements are an integral part of these statements. Each year has been revised. See Note 2 section entitled "Restatements and Reclassifications". 6
FINANCIAL SECURITY ASSURANCE HOLDINGS LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1. ORGANIZATION AND OWNERSHIP Financial Security Assurance Holdings Ltd. (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 asset-backed and municipal obligations. The Company's underwriting policy is to insure asset-backed and municipal obligations that it determines would be of investment-grade quality without the benefit of the Company's insurance. 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 or trade receivables, securities or other assets having an ascertainable cash flow or market value. The municipal obligations insured by the Company consist primarily of general obligation bonds that are supported by the issuers' taxing power and of special revenue bonds and other special obligations of states and local governments that are supported by the issuers' ability to impose and collect fees and charges for public services or specific projects. 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 asset-backed and municipal obligations, with a broad geographic distribution and a variety of revenue sources and transaction structures. The Company's insured portfolio consists primarily of asset-backed and municipal obligations originated in the United States, but the Company has also written and continues to pursue business in Europe and the Asia Pacific region. At December 31, 1996, the Company was owned 40.4% by U S WEST Capital Corporation (U S WEST), 11.5% by Fund American Enterprises Holdings, Inc. (Fund American), 6.4% by The Tokio Marine and Fire Insurance Co., Ltd. (Tokio Marine) and 41.7% by the public and employees. At December 31, 1997, the Company was owned 42.1% by U S WEST, 12.0% by Fund American, 6.7% by Tokio Marine and 39.2% by the public and employees. On November 3, 1998, the Company issued 1,632,653 common shares out of treasury to XL Capital Ltd (XL), which was named EXEL Limited until February 1999, in exchange for $80,000,000 of XL's common stock in conjunction with the creation of a new subsidiary (see Note 7). At December 31, 1998, the Company was owned 40.5% by MediaOne Capital Corporation (MediaOne), formerly U S WEST, 11.6% by Fund American, 6.4% by Tokio Marine, 5.5% by XL and 36.0% by the public and employees. These percentages are calculated based upon outstanding shares, which are reduced by treasury shares as presented in these financial statements. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accompanying financial statements have been prepared in accordance with generally accepted accounting principles (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 and disclosure of contingent assets and liabilities in the Company's consolidated balance sheets at December 31, 1998 and 1997 and the reported amounts of revenues and expenses in the consolidated statements of income during the years ended December 31, 1998, 1997 and 1996. Such estimates and assumptions include, but are not limited to, losses and loss adjustment expenses and the deferral and amortization of deferred policy acquisition costs. Actual results may differ from those estimates. Significant accounting policies under GAAP are as follows: 7
Basis of Presentation The consolidated financial statements include the accounts of the Company and its direct and indirect subsidiaries, FSA Portfolio Management Inc., Transaction Services Corporation, Financial Security Assurance Inc. (FSA), FSA Insurance Company, Financial Security Assurance International Ltd., Financial Security Assurance of Oklahoma, Inc. and Financial Security Assurance (U.K.) Limited (collectively, the Subsidiaries). All intercompany accounts and transactions have been eliminated. Certain prior-year balances have been reclassified to conform to the 1998 presentation. Investments Investments in debt securities designated as available for sale are carried at market value. Equity investments are carried at market value. Any resulting unrealized gain or loss is reflected as a separate component of shareholders' equity, net of applicable deferred income taxes. Except as specified in Note 20, all of the Company's long-term investments are classified as available for sale. 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 market value, which approximates cost. Realized gains or losses on sale of investments are determined on the basis of specific identification. Investment income is recorded as earned. The Company holds derivative securities, including U.S. Treasury bond futures contracts and call option contracts, that are not accounted for as hedges and are marked-to-market on a daily basis. Any gains or losses are included in capital gains or losses. Investments in unconsolidated affiliates are carried on the equity basis (see Note 20). Premium Revenue Recognition Gross and ceded premiums are earned in proportion to the amount of risk outstanding over the expected period of coverage. The amount of risk outstanding is equal to the sum of the par amount of debt insured. Deferred premium revenue and prepaid reinsurance premiums represent the portion of premium 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. Losses and Loss Adjustment Expenses A case basis reserve for unpaid losses and loss adjustment expenses is recorded at the present value of the estimated loss when, in management's opinion, the likelihood of a future loss is probable and determinable at the balance sheet date. The estimated loss on a transaction is discounted using current risk-free rates ranging from 5.5% to 6.1%. The general reserve is calculated by applying a loss factor to the total net par amount outstanding of the Company's insured obligations over the term of such insured obligations and discounting the result at risk-free rates. The loss factor used for this purpose has been determined based upon an independent rating agency study of bond defaults and the Company's portfolio characteristics and history. The general reserve is available to be applied against future additions or accretions to existing case basis reserves or to new case basis reserves to be established in the future. Management of the Company periodically evaluates its estimates for losses and loss adjustment expenses and establishes reserves that management believes are adequate to cover the present value of the ultimate net cost of claims. The reserves are necessarily based on estimates, and there can be no assurance that the ultimate liability will not differ from such estimates. The Company will, on an ongoing basis, monitor these reserves and may 8
periodically adjust such reserves based on the Company's actual loss experience, its future mix of business, and future economic conditions. Deferred Acquisition Costs Deferred acquisition costs comprise those expenses that vary with and are primarily 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 income on premiums ceded to reinsurers. Deferred acquisition costs and the cost of acquired business are amortized over the period in which the related premiums are earned. Recoverability of deferred acquisition costs is determined by considering anticipated losses and loss adjustment expenses. Federal Income Taxes The provision for income taxes consists of an amount for taxes currently payable and a provision for tax consequences deferred to future periods reflected at current income tax rates. Earnings per Common Share In 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share (EPS), specifying the computation, presentation and disclosure requirements for EPS (see Note 18). The new standard defines "basic" and "diluted" earnings per share. Basic earnings per share are based on average basic shares outstanding, which is calculated by adding shares earned but not issued under the Company's equity bonus and performance share programs to the average common shares outstanding. Diluted earnings per share are based on average diluted shares outstanding, which is calculated by adding shares contingently issuable under stock options, the performance share program and the Company's redeemable preferred stock to the average basic shares outstanding. All earnings per share have been restated to reflect the adoption of SFAS No. 128. Segment Reporting In 1997, the Financial Accounting Standards Board issued SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information, establishing standards for the way that public business enterprises report information about operating segments in annual and interim financial statements and requiring presentation of a measure of profit or loss, certain specific revenue and expense items and segment assets. The Company has no reportable operating segments as a monoline financial guaranty insurer. Restatements and Reclassifications: In May 1996, the Company entered into a forward share purchase agreement with two financial institutions, under which it had the ability to acquire up to 1,750,000 shares of its stock for $26.50 plus accumulated financing charges. The Company retained the economic interest in 1,000,000 shares and passed both the economic risk and reward in the remaining 750,000 shares on to a group of the Company's employees and directors, who were required to post collateral against the risk of a decline in market value of the shares The Company accounted for the 1,000,000 share obligation under the "permanent equity" provisions of EITF 96-13, which resulted in no impact on the Company's financial statements until the shares were acquired as treasury stock in December 1997. With regard to the 750,000 shares made available to employees and directors, of which 529,122 shares remain outstanding, the Company offset the gain on the forward share agreement against the corresponding increased liability to the employees and directors, resulting in no net impact on the Company's financial statements until settlement. At settlement, the Company's paid-in surplus is credited with the tax savings resulting from the transaction. During a review of the Company's shelf registration statement in April 1999, the Securities and Exchange Commission (SEC) staff advised the Company that, in its opinion, the gain on the forward purchase agreement should not be used to offset the additional liability to the employees and directors. After discussion with the SEC staff, the Company has revised its accounting to recognize the liability as incurred and to recognize the offsetting gain on the forward purchase agreement as an addition to paid-in surplus upon settlement (assuming cash 9
settlement). The effect of this change in accounting for the forward share purchase agreements was to (decrease) the amounts previously reported as shown below (in thousands, except per share data): 1998 1997 1996 ---- ---- ---- Income before income taxes ($2,495) ($8,951) ($4,208) Net Income (1,622) (5,818) (2,735) EPS - Basic (.06) (.19) (.09) EPS - Diluted (.05) (.19) (.09) Shareholder's Equity (7,300) (6,411) In addition, the Company reclassified the redeemable preferred stock outside of shareholder's equity, which decreased shareholder's equity as of December 31, 1998 and 1997 by $700,000. Historically, purchases of tax and loss bonds were treated as charges to current tax expense with a corresponding benefit to deferred taxes by setting up tax and loss bonds as a deferred tax asset (i.e., reduction of the deferred tax liability). These purchases have been reclassified to be treated as prepaid federal income taxes and, as a consequence, tax and loss bonds have been classified as an asset on the balance sheet and not as a reduction of the deferred tax liability. Accordingly, the change had the effect of increasing both assets and liabilities by $38,726,000 and $30,520,000 at December 31, 1998 and 1997, respectively. This reclassification has no effect on the Company's net income or shareholders' equity. 3. INVESTMENTS Bonds at amortized cost of $11,481,000 and $11,025,000 at December 31, 1998 and 1997, respectively, were on deposit with state regulatory authorities as required by insurance regulations. Consolidated net investment income consisted of the following (in thousands): Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- Bonds $ 71,888 $ 65,422 $ 61,740 Equity investments 1,075 1,393 928 Short-term investments 8,391 7,206 3,966 Investment expenses (2,531) (1,936) (1,570) -------- -------- -------- Net investment income $ 78,823 $ 72,085 $ 65,064 ======== ======== ======== The credit quality of the fixed-income investment portfolio at December 31, 1998 was as follows: Percent of Fixed-Income Rating Investment Portfolio ----------------------- ---------------------------- AAA 66.0% AA 20.4 A 12.9 BBB 0.4 Other 0.3 10
The amortized cost and estimated market value of bonds were as follows (in thousands): Gross Gross Amortized Unrealized Unrealized Estimated December 31, 1998 Cost Gains Losses Market Value ---- ----- ------ ------------ U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 148,669 $ 2,432 $ (336) $ 150,765 Obligations of states and political subdivisions 1,041,718 42,265 (637) 1,083,346 Mortgage-backed securities 266,770 3,920 (190) 270,500 Corporate securities 164,697 5,539 (463) 169,773 Asset-backed securities 33,188 494 (26) 33,656 ---------- ---------- ---------- ---------- Total $1,655,042 $ 54,650 $ (1,652) $1,708,040 ========== ========== ========== ========== December 31, 1997 U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 122,817 $ 799 $ (454) $ 123,162 Obligations of states and political subdivisions 777,042 40,187 (135) 817,094 Foreign securities 48,078 -- (6,126) 41,952 Mortgage-backed securities 195,567 2,213 (27) 197,753 Corporate securities 66,014 1,375 (501) 66,888 Asset-backed securities 20,961 349 (1) 21,309 ---------- ---------- ---------- ---------- Total $1,230,479 $ 44,923 $ (7,244) $1,268,158 ========== ========== ========== ========== The change in net unrealized gains (losses) consisted of (in thousands): Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- Bonds $ 15,319 $ 23,657 $(16,640) Equity investments 2,842 1,109 -- Other 1,017 -- -- -------- -------- -------- Change in net unrealized gains (losses) $ 19,178 $ 24,766 $(16,640) ======== ======== ======== 11
The amortized cost and estimated market value of bonds at December 31, 1998, 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. Estimated Amortized Cost Market Value -------------- ------------ Due in one year or less $ 1,002 $ 1,006 Due after one year through five years 137,094 139,642 Due after five years through ten years 225,259 233,080 Due after ten years 991,729 1,030,156 Mortgage-backed securities (stated maturities of 1 to 30 years) 266,770 270,500 Asset-backed securities (stated maturities of 25 to 30 years) 33,188 33,656 ---------- ---------- Total $1,655,042 $1,708,040 ========== ========== Proceeds from sales of bonds during 1998, 1997 and 1996 were $1,889,130,000, $1,127,749,000 and $1,118,112,000, respectively. Gross gains of $28,322,000, $12,627,000 and $15,335,000 and gross losses of $8,585,000, $1,433,000 and $12,146,000 were realized on sales in 1998, 1997 and 1996, respectively. Proceeds from sales of equity investments during 1998 and 1997 were $33,613,000 and $3,568,000, respectively. Gross gains of $2,684,000 and $33,000 and gross losses of $1,331,000 and $7,000 were realized on sales in 1998 and 1997, respectively. The Company held open positions in U.S. Treasury bond futures contracts with an aggregate notional amount of $57,700,000 and $33,300,000 as of December 31, 1998 and 1997, respectively. The Company also held open positions in Eurodollar futures contracts with an aggregate notional amount of $1,000,000 as of December 31, 1998. Such positions are marked-to-market on a daily basis and, for the years ended December 31, 1998, 1997 and 1996, resulted in net realized gains of $883,000, $190,000 and $923,000, respectively, which are included in gross realized capital gains, above. 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, ----------------------- 1998 1997 1996 ---- ---- ---- Balance, beginning of period $171,098 $146,233 $132,951 -------- -------- -------- Costs deferred during the period: Ceding commission income (27,693) (18,956) (15,956) Assumed commission expense 22 31 38 Premium taxes 8,081 5,554 3,718 Compensation and other acquisition costs 83,490 66,198 49,311 -------- -------- -------- Total 63,900 52,827 37,111 -------- -------- -------- Costs amortized during the period (35,439) (27,962) (23,829) -------- -------- -------- Balance, end of period $199,559 $171,098 $146,233 ======== ======== ======== 12
5. STATUTORY ACCOUNTING PRACTICES GAAP for the Subsidiaries differs in certain significant respects from accounting practices prescribed or permitted by insurance regulatory authorities. The principal differences result from the following statutory accounting practices: - Upfront premiums on municipal business 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 general reserve) is computed based on the following statutory requirements: (i) For all policies written prior to July 1, 1989, an amount equal to 50% of cumulative earned premiums less permitted reductions, plus; (ii) 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; - Federal income taxes are provided only on taxable income for which income taxes are currently payable, including the purchase of tax and loss bonds; - Accruals for deferred compensation are not recognized; - Purchase accounting adjustments are not recognized; - Bonds are carried at amortized cost; - Surplus notes are recognized as surplus rather than a liability. A reconciliation of net income for the calendar years 1998, 1997 and 1996 and shareholders' equity at December 31, 1998 and 1997, reported by the Company on a GAAP basis, to the amounts reported by the Subsidiaries on a statutory basis, is as follows (in thousands): Net Income: 1998 1997 1996 ---- ---- ---- GAAP BASIS $115,356 $ 94,684 $ 78,025 Non-insurance companies net loss (gain) 5,461 5,575 2,830 Premium revenue recognition (16,411) (23,130) (5,518) Losses and loss adjustment expenses incurred 12,938 4,653 (2,138) Deferred acquisition costs (28,461) (24,865) (12,482) Deferred income tax provision 167 16,019 12,321 Current income tax (8,206) (7,994) (11,410) Amortization of bonds -- 56 566 Accrual of deferred compensation, net 33,268 26,681 12,737 Other 100 (61) 1,404 -------- -------- -------- STATUTORY BASIS $114,212 $ 91,618 $ 76,335 ======== ======== ======== 13
December 31, ------------ Shareholders' Equity: 1998 1997 ---- ---- GAAP BASIS $1,065,436 $ 875,249 Non-insurance companies liabilities, net 39,155 22,611 Premium revenue recognition (91,297) (74,863) Loss and loss adjustment expense reserves 47,250 34,313 Deferred acquisition costs (199,559) (171,098) Contingency reserve (367,454) (287,694) Unrealized gain on investments, net of tax (55,851) (43,027) Deferred income taxes 95,398 90,387 Tax and loss bonds (38,726) (30,520) Accrual of deferred compensation 70,022 41,451 Surplus notes 120,000 50,000 Other (14,118) (12,841) ---------- ---------- STATUTORY BASIS SURPLUS $ 670,256 $ 493,968 ========== ========== SURPLUS PLUS CONTINGENCY RESERVE $1,037,710 $ 781,661 ========== ========== 6. FEDERAL INCOME TAXES The Company and its Subsidiaries (except Financial Security Assurance International Ltd.) file a consolidated federal income tax return. The calculation of each member's tax benefit or liability is controlled by a tax sharing agreement that bases the allocation of such benefit or liability upon a separate return calculation. Prior to 1998, purchases of tax and loss bonds were treated as charges to current tax expense with a corresponding benefit to deferred taxes by setting up tax and loss bonds as a deferred tax asset (i.e., reduction of the deferred tax liability). Beginning in 1998, these purchases have been treated as prepaid federal income taxes and, as a consequence, tax and loss bonds have been treated as an asset on the balance sheet and not as a reduction of the deferred tax liability. Accordingly, the change had the effect of increasing both assets and liabilities by $38,726,000 and $30,520,000 at December 31, 1998 and 1997, respectively. In addition, this change had the effect of increasing the deferred tax provision and decreasing the current tax provision by $8,206,000, $7,994,000, and $11,410,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The cumulative balance sheet effects of deferred tax consequences are (in thousands): December 31, ------------ 1998 1997 ---- ---- Deferred acquisition costs $ 69,079 $ 59,884 Deferred premium revenue adjustments 10,354 8,424 Unrealized capital gains 21,134 15,618 Contingency reserves 46,260 38,037 -------- -------- Total deferred tax liabilities 146,827 121,963 -------- -------- Loss and loss adjustment expense reserves (16,613) (12,009) Deferred compensation (41,545) (26,109) Other, net (1,415) (1,059) -------- -------- Total deferred tax assets (59,573) (39,177) -------- -------- Total deferred income taxes $ 87,254 $ 82,786 ======== ======== 14
No valuation allowance was necessary at December 31, 1998 or 1997. A reconciliation of the effective tax rate with the federal statutory rate follows: Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- Tax at statutory rate 35.0% 35.0% 35.0% Tax-exempt interest (8.6) (8.4) (9.3) Other 0.3 0.3 0.4 ---- ---- ---- Provision for income taxes 26.7% 26.9% 26.1% ==== ==== ==== 7. SHAREHOLDERS' EQUITY AND REDEEMABLE PREFERRED STOCK On September 2, 1994, the Company issued to Fund American 2,000,000 shares of Series A, non-dividend paying, voting, redeemable preferred stock having an aggregate liquidation preference of $700,000. The preferred stock is redeemable, at the option of the holder upon payment of the conversion price therefor, into an equal number of shares of common stock (subject to anti-dilutive adjustment). The conversion price per share (subject to anti-dilutive adjustment) is $29.65. The preferred stock will be redeemed (if then outstanding) on May 13, 2004 at a redemption price of $0.35 per share. Fund American is entitled to one vote per share of redeemable preferred stock, voting together as a single class with the holders of common stock on all matters upon which holders of common stock are entitled to vote. As the holder of the redeemable preferred stock, Fund American is not entitled to receive dividends or other distributions of any kind payable to shareholders of the Company, except that, in the event of the liquidation, dissolution or winding up of the Company, it is entitled to receive out of the assets of the Company available therefor, before any distribution or payment is made to the holders of common stock or to any other class of capital stock of the Company ranking junior to the Company's preferred stock, liquidation payments in the amount of $0.35 per share. Fund American may not transfer the redeemable preferred stock, except to one of its majority-owned subsidiaries. In May 1996, the Company repurchased 1,000,000 shares of its common stock from U S WEST for a purchase price of $26.50 per share. At the same time, the Company also entered into forward agreements with two financial institutions (the Counterparties) in respect of 1,750,000 shares (the Forward Shares) of the Company's common stock. Under the forward agreements, the Company has the obligation either: (i) to purchase the Forward Shares from the Counterparties for a price equal to $26.50 per share plus carrying costs or (ii) to direct the Counterparties to sell the Forward Shares, with the Company receiving any excess or making up any shortfall between the sale proceeds and $26.50 per share plus carrying costs in cash or additional shares, at its option. At the same time it entered into the forward agreements, the Company made the economic benefit and risk of 750,000 of these shares available for subscription by certain of the Company's employees and directors. When an individual participant exercises Forward Shares under the subscription program, the Company settles with the participant but does not necessarily close out the corresponding forward share position with the Counterparties. These settlements during 1998 and 1997 were $733,000 and $2,142,000, respectively. By the fourth quarter of 1997, such exercises by participants had increased the number of shares allocated to the Company from 1,000,000 shares to 1,187,800 shares. During the fourth quarter of 1997, the Company purchased 1,187,800 Forward Shares for $33,910,000 by exercising rights under the forward agreements. At December 31, 1998, 562,200 Forward Shares remained in the program. Of these, 33,078 shares were held for the benefit of the Company as a result of the repurchase of Forward Shares from employees and directors, and 529,122 shares continued to be held for the benefit of employees and directors. The Company has recognized compensation expense for the difference between the carrying cost and the market value at December 31, 1998, 1997 and 1996 of $2,495,000, $8,951,000 and $4,208,000, respectively. On November 3, 1998, the Company and XL closed a transaction to create two new Bermuda-based financial guaranty insurance companies. Each of the new companies has been initially capitalized with approximately $100,000,000. One company, Financial Security Assurance International Ltd., is an indirect subsidiary of FSA, and the other company, XL Financial Assurance Ltd, is a subsidiary of XL. The Company has a minority interest in the XL subsidiary, and XL has a minority interest in the FSA indirect subsidiary. In conjunction with forming the new companies, the Company and XL exchanged $80,000,000 of their respective common shares, with the Company delivering to XL 1,632,653 common shares out of treasury. Prior to the closing of the transaction with XL, the Company had entered into an agreement with an unrelated third party to sell for cash, at no gain or loss, 15
$60,000,000 of the XL shares. This $60,000,000 was used to fund, in part, the Company's investment in Financial Security Assurance International Ltd. 8. DIVIDENDS AND CAPITAL REQUIREMENTS Under New York Insurance Law, FSA may pay a dividend to the Company without the prior approval of the Superintendent of the New York State Insurance Department only from earned surplus subject to the maintenance of a minimum capital requirement. In addition, the dividend, together with all dividends declared or distributed by FSA during the preceding twelve months, may not exceed the lesser of 10% of its policyholders' surplus shown on FSA's last filed statement, or adjusted net investment income, as defined, for such twelve-month period. As of December 31, 1998, FSA had $65,726,000 available for the payment of dividends over the next twelve months. In addition, the Company holds $120,000,000 of surplus notes of FSA. Payments of principal or interest on such notes may be made with the approval of the New York Insurance Department. In 1998, FSA repurchased $8,500,000 of its shares from its parent, representing the balance remaining of $75,000,000 that had been approved for repurchase by the New York Insurance Department. 9. CREDIT ARRANGEMENTS AND ADDITIONAL CLAIMS-PAYING RESOURCES FSA has a credit arrangement aggregating $150,000,000 at December 31, 1998, which is provided by commercial banks and intended for general application to transactions insured by the Subsidiaries. At December 31, 1998, there were no borrowings under this arrangement, which expires on November 23, 1999. In addition, there are credit arrangements assigned to specific insured transactions. In August 1994, FSA entered into a facility agreement with Canadian Global Funding Corporation and Hambros Bank Limited. Under the agreement, which expires in August 2004, FSA can arrange financing for transactions subject to certain conditions. The amount of this facility was $186,911,000, of which $44,974,000 was unutilized at December 31, 1998. FSA has a standby line of credit commitment in the amount of $240,000,000 with a group of international Aaa/AAA-rated 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 $230,000,000 or 5.75% of average annual debt service of the covered portfolio. 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 beginning on April 30, 1997 and expiring on April 30, 2004 and contains an annual renewal provision subject to approval by the banks. No amounts have been utilized under this commitment as of December 31, 1998. On September 18, 1997, the Company issued $130,000,000 of 7.375% Senior Quarterly Income Debt Securities (Senior QUIDS) due September 30, 2097 and callable without premium or penalty on or after September 18, 2002. Interest on these notes is paid quarterly beginning on December 31, 1997. Debt issuance costs of $4,320,000 are being amortized over the life of the debt. The Company used the proceeds to repay $30,000,000 of outstanding notes, to augment capital in the Subsidiaries, to repurchase Forward Shares (see Note 7) and for general corporate purposes. On November 13, 1998, the Company issued $100,000,000 of 6.95% Senior QUIDS due November 1, 2098 and callable without premium or penalty on or after November 1, 2003. Interest is paid quarterly beginning on February 1, 1999. Debt issuance costs of $3,375,000 are being amortized over the life of the debt. The Company used the proceeds to augment capital in the Subsidiaries and for general corporate purposes. 10. EMPLOYEE BENEFIT PLANS The Subsidiaries maintain both a qualified and a non-qualified non-contributory defined contribution pension plan for the benefit of all eligible employees. The Subsidiaries' contributions are based upon a fixed percentage of employee compensation. Pension expense, which is funded as accrued, amounted to $2,584,000, $2,535,000 and $2,215,000 for the years ended December 31, 1998, 1997 and 1996, respectively. 16
The Subsidiaries have an employee retirement savings plan for the benefit of all eligible employees. The plan permits employees to contribute a percentage of their salaries up to limits prescribed by the Internal Revenue Service (IRS Code, Section 401(k)). The Subsidiaries' contributions are discretionary, and none have been made. Pursuant to the 1993 Equity Participation Plan, 1,810,780 shares of common stock, subject to anti-dilutive adjustment, were reserved for awards of options, restricted shares of common stock, and performance shares to employees for the purpose of providing, through the grant of long-term incentives, a means to attract and retain key personnel and to provide to participating officers and other key employees long-term incentives for sustained high levels of performance. Shares available under the 1993 Equity Participation Plan were increased from 1,810,780 to 2,110,780 in December 1995. The 1993 Equity Participation Plan also contains provisions that permit the Human Resources Committee to pay all or a portion of employees' bonuses in the form of shares of common stock credited to the employees at a 15% discount from current market value and paid to employees five years from the date of award. Up to an aggregate of 10,000,000 shares may be allocated to such equity bonuses. Common stock to pay performance shares, stock options and equity bonus awards is acquired by the Company through open-market purchases by a trust established for such purpose. Performance shares are awarded under the Company's 1993 Equity Participation Plan. The Plan authorizes the discretionary grant of performance shares by the Human Resources Committee to key employees of the Company and its subsidiaries. The number of shares of the Company's common stock earned for each performance share depends upon the attainment by the Company of certain growth rates of adjusted book value per outstanding share over a three-year period. At each payout date, each performance share is adjusted to pay out from zero up to two common shares. No common shares are paid out if the compound annual growth rate of the Company's adjusted book value per outstanding share was less than 7%. Two common shares per performance share are paid out if the compound annual growth rate was 19% or greater. Payout percentages are interpolated for compound annual growth rates between 7% and 19%. Performance shares granted under the 1993 Equity Participation Plan were as follows: Outstanding Granted Earned Forfeited Outstanding Market at Beginning During During During at End Price at of Year the Year the Year the Year of Year Grant Date ------- -------- -------- -------- ------- ---------- 1996 1,109,150 282,490 -- 17,300 1,374,340 $25.2500 1997 1,374,340 253,057 201,769 59,253 1,366,375 35.5000 1998 1,366,375 273,656 229,378 26,145 1,384,508 46.0625 The Company applies APB Opinion 25 and related Interpretations in accounting for its performance shares. The Company estimates the final cost of these performance shares and accrues for this expense over the performance period. The accrued expense for the performance shares was $40,862,000, $29,500,000 and $13,741,000 for the years ended December 31, 1998, 1997 and 1996, respectively. In tandem with this accrued expense, the Company estimates those performance shares that it expects to settle in stock and records this amount in shareholders' equity as deferred compensation. The remainder of the accrual, which represents the amount of performance shares that the Company estimates it will settle in cash, is recorded in accrued expenses and other liabilities. In 1996, the Company adopted disclosure provisions of SFAS No. 123. Had the compensation cost for the Company's performance shares been determined based upon the provisions of SFAS No. 123, there would have been no effect on the Company's reported net income and earnings per share. In November 1994, the Company appointed an independent trustee authorized to purchase shares of the Company's common stock in open market transactions, at times and prices determined by the trustee. These purchases are intended to fund future obligations relating to equity bonuses, performance shares and stock options under the 1993 Equity Participation Plan and other employee benefit plans and are presented as treasury stock in these financial statements. During 1998, 1997 and 1996, the total number of shares purchased by the trust was 496,940, 162,573 and 529,131, respectively, at a cost of $23,907,000, $5,434,000 and $14,111,000, respectively. In 1996, the Company also repurchased stock from its employees in satisfaction of withholding taxes on shares distributed under its restricted stock plan. 17
The Company does not currently provide post-retirement benefits, other than under its defined contribution plans, to its employees, nor does it provide post-employment benefits to former employees other than under its severance plans. 11. COMMITMENTS AND CONTINGENCIES The Company and its Subsidiaries lease office space and equipment under non-cancelable operating leases, which expire at various dates through 2005. Future minimum rental payments are as follows (in thousands): Year Ended December 31, ----------------------- 1999 $ 2,489 2000 2,327 2001 2,014 2002 1,739 2003 1,739 Thereafter 3,333 ------- Total $13,641 ======= Rent expense for the years ended December 31, 1998, 1997 and 1996 was $4,372,000, $4,067,000 and $3,816,000, respectively. During the ordinary course of business, the Company and its Subsidiaries become parties to certain litigation. Management believes that these matters will be resolved with no material impact on the Company's financial position, results of operations or cash flows. 12. REINSURANCE The Subsidiaries reinsure portions of their risks with affiliated (see Note 14) and unaffiliated reinsurers under quota share and first-loss treaties and on a facultative basis. The Subsidiaries' principal ceded reinsurance program consisted in 1998 of two quota share treaties, one first-loss treaty and four automatic facultative facilities. One treaty covered all of the Subsidiaries' approved regular lines of business, except U.S. municipal obligation insurance. Under this treaty in 1998, the Subsidiaries ceded 6.75% of each covered policy, up to a maximum of $13,500,000 insured principal per policy. At their sole option, the Subsidiaries could have increased, and in certain instances did increase, the ceding percentage to 13.5% up to $27,000,000 of each covered policy. A second treaty covered the Subsidiaries' U.S. municipal obligation insurance business. Under this treaty in 1998, the Subsidiaries ceded 6% of each covered policy that is classified by the Subsidiaries as providing U.S. municipal bond insurance as defined by Article 69 of the New York Insurance Law up to a limit of $16,000,000 per single risk, which is defined by revenue source. At their sole option, the Subsidiaries could have increased, and in certain instances did increase, the ceding percentage to 30% up to $80,000,000 per single risk. These cession percentages under both treaties were reduced on smaller-sized transactions. The first-loss treaty applied to qualifying U.S. mortgage-backed transactions. Under the four automatic facultative facilities in 1998, the Subsidiaries at their option could allocate up to a specified amount for each reinsurer (ranging from $4,000,000 to $40,000,000 depending on the reinsurer) for each transaction, subject to limits and exclusions, in exchange for which the Subsidiaries agreed to cede in the aggregate a specified percentage of gross par insured by the Subsidiaries. Each of the quota share treaties and automatic facultative facilities allowed the Subsidiaries to withhold a ceding commission to defray their expenses. The Subsidiaries also employed non-treaty quota share and first-loss facultative reinsurance on various transactions in 1998. In the event (which management considers to be highly unlikely) that any or all of the reinsuring companies were unable to meet their obligations to the Subsidiaries, the Subsidiaries would be liable for such defaulted 18
amounts. The Subsidiaries have also assumed reinsurance of municipal obligations from unaffiliated insurers. Amounts reinsured were as follows (in thousands): Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- Written premiums ceded $99,413 $63,513 $55,965 Written premiums assumed 935 1,352 1,873 Earned premiums ceded 55,939 41,713 38,723 Earned premiums assumed 4,271 5,121 6,020 Loss and loss adjustment expense payments ceded 22,619 2,862 29,408 Loss and loss adjustment expense payments assumed 3 2 3 Incurred (recovered) losses and loss adjustment expenses ceded (4,673) 3,605 (2,249) Incurred (recovered) losses and loss adjustment expenses assumed (139) 161 38 December 31, ------------ 1998 1997 ---- ---- Principal outstanding ceded $32,914,844 $24,547,361 Principal outstanding assumed 1,360,916 1,670,468 Deferred premium revenue ceded 217,096 173,123 Deferred premium revenue assumed 10,799 14,128 Loss and loss adjustment expense reserves ceded 3,907 30,618 Loss and loss adjustment expense reserves assumed 723 865 13. OUTSTANDING EXPOSURE AND COLLATERAL The Company's policies insure the scheduled payments of principal and interest on asset-backed and municipal obligations. The principal amount insured (in millions) as of December 31, 1998 and 1997 (net of amounts ceded to other insurers) and the terms to maturity are as follows: December 31, 1998 December 31, 1997 ----------------- ----------------- Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal - ----------------- ------------ --------- ------------ --------- 0 to 5 Years $ 8,468 $ 2,756 $ 7,553 $ 2,230 5 to 10 Years 7,516 7,495 5,637 5,683 10 to 15 Years 5,661 12,427 2,858 8,257 15 to 20 Years 670 20,265 524 14,340 20 Years and Above 15,308 24,107 11,917 16,479 ------- ------- ------- ------- Total $37,623 $67,050 $28,489 $46,989 ======= ======= ======= ======= The principal amount ceded as of December 31, 1998 and 1997 and the terms to maturity are as follows (in millions): December 31, 1998 December 31, 1997 ----------------- ----------------- Terms to Maturity Asset-Backed Municipal Asset-Backed Municipal - ----------------- ------------ --------- ------------ --------- 0 to 5 Years $ 2,727 $ 1,157 $ 3,828 $ 965 5 to 10 Years 1,859 2,143 2,118 1,693 10 to 15 Years 1,116 3,022 553 2,078 15 to 20 Years 591 4,852 257 3,005 19
20 Years and Above 3,230 12,218 3,373 6,677 ------- ------- ------- ------- Total $ 9,523 $23,392 $10,129 $14,418 ======= ======= ======= ======= 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 gross principal amounts of insured obligations in the asset-backed insured portfolio are backed by the following types of collateral (in millions): Net of Amounts Ceded Ceded December 31, December 31, ------------ ------------ Types of Collateral 1998 1997 1998 1997 - ------------------- ---- ---- ---- ---- Residential mortgages $15,647 $12,928 $ 3,324 $ 3,665 Consumer receivables 12,539 10,659 3,663 4,601 Government securities 821 787 267 120 Pooled corporate obligations 6,776 3,004 1,388 540 Commercial mortgage portfolio: Commercial real estate 15 98 49 418 Corporate secured 42 55 314 481 Investor-owned utility obligations 757 643 464 229 Other asset-backed obligations 1,026 315 54 75 ------- ------- ------- ------- Total asset-backed obligations $37,623 $28,489 $ 9,523 $10,129 ======= ======= ======= ======= The asset-backed insured portfolio, which aggregated $47,146,604,000 of principal before reinsurance at December 31, 1998, was collateralized by assets with an estimated fair value of $53,754,485,000. At December 31, 1997, it aggregated $38,618,244,000 of principal before reinsurance and was collateralized by assets with an estimated fair value of $44,382,716,000. Such estimates of fair value are calculated at the inception of each insurance policy and are changed only in proportion to changes in exposure. At December 31, 1998, the estimated fair value of collateral and reserves over the principal insured averaged from 110% for commercial real estate to 181% for corporate secured obligations. At December 31, 1997, the estimated fair value of collateral and reserves over the principal insured averaged from 100% for commercial real estate to 172% for corporate secured obligations. Collateral for specific transactions is generally not available to pay claims related to other transactions. The amounts of losses ceded to reinsurers are determined net of collateral. The gross principal amount of insured obligations in the municipal insured portfolio includes the following types of issues (in millions): Net of Amounts Ceded Ceded December 31, December 31, ------------ ------------ Types of Issues 1998 1997 1998 1997 - --------------- ---- ---- ---- ---- General obligation bonds $25,337 $17,101 $ 4,517 $ 3,182 Housing revenue bonds 2,509 1,770 1,108 955 Municipal utility revenue bonds 9,218 5,892 5,489 2,294 Health care revenue bonds 5,812 3,924 3,348 2,175 Tax-supported bonds (non-general obligation) 14,731 11,210 5,238 3,526 Transportation revenue bonds 2,937 1,972 2,154 1,041 Other municipal bonds 6,506 5,120 1,538 1,245 ------- ------- ------- ------- Total municipal obligations $67,050 $46,989 $23,392 $14,418 ======= ======= ======= ======= 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 securitization, the geographic 20
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. 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, by state, those states in which municipalities located therein issued an aggregate of 2% or more of the Company's net par amount outstanding of insured municipal securities as of December 31, 1998: Net Par Percent of Total Ceded Par Number Amount Municipal Net Par Amount State of Issues Outstanding Amount Outstanding Outstanding ----- --------- ----------- ------------------ ----------- (in millions) (in millions) California 517 $10,233 15.3% $ 3,103 New York 388 5,836 8.7 4,137 Pennsylvania 356 4,821 7.2 834 Texas 414 4,128 6.1 1,441 Florida 130 4,091 6.1 1,616 New Jersey 275 3,475 5.2 1,486 Illinois 359 3,125 4.7 628 Massachusetts 126 2,259 3.4 976 Michigan 217 2,161 3.2 511 Wisconsin 252 1,685 2.5 228 Indiana 103 1,461 2.2 162 Minnesota 146 1,340 2.0 191 All Other States 1,453 20,993 31.3 6,812 Non-U.S 32 1,442 2.1 1,267 ----- ------- ----- ------- Total 4,768 $67,050 100.0% $23,392 ===== ======= ===== ======= 14. RELATED PARTY TRANSACTIONS The Subsidiaries ceded premiums of $23,838,000, $21,216,000 and $19,890,000 to Tokio Marine for the years ended December 31, 1998, 1997 and 1996, respectively. The amounts included in prepaid reinsurance premiums at December 31, 1998 and 1997 for reinsurance ceded to Tokio Marine were $62,422,000 and $53,603,000, respectively. Reinsurance recoverable on unpaid losses ceded to Tokio Marine was $612,000 and $613,000 at December 31, 1998 and 1997, respectively. The Subsidiaries ceded losses and loss adjustment expenses of $603,000, $1,095,000 and $232,000 to Tokio Marine for the years ended December 31, 1998, 1997 and 1996, respectively. The Subsidiaries ceded premiums of $7,297,000 and $15,000 to X.L. Insurance Company, Ltd., a subsidiary of XL, for the years ended December 31, 1998 and 1997, respectively. The amounts included in prepaid reinsurance premiums at December 31, 1998 and 1997 for reinsurance ceded to X.L. Insurance Company, Ltd. were $5,306,000 and $6,000, respectively. The Subsidiaries ceded premiums of $25,862,000, $16,890,000 and $15,409,000 on a quota share basis to affiliates of MediaOne (Enhance Reinsurance Company, Asset Guaranty Insurance Company and Commercial Reinsurance Company) for the years ended December 31, 1998, 1997 and 1996, respectively. The amounts included in prepaid reinsurance premiums for reinsurance ceded to these affiliates were $61,088,000 and $51,980,000 at December 31, 1998 and 1997, respectively. The amounts of reinsurance recoverable on unpaid losses ceded to these affiliates at December 31, 1998 and 1997 were $1,755,000 and $24,195,000, respectively. The Subsidiaries ceded losses and loss adjustment expenses (recoveries) of $(11,956,000), $2,105,000 and $(3,316,000) to these affiliates for the years ended December 31, 1998, 1997 and 1996, respectively. 15. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS 21
The following estimated fair values have been determined by the Company 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. Bonds -- The carrying amount of bonds represents fair value. The fair value of bonds is based upon quoted market price. Short-term investments -- The carrying amount is fair value, which approximates cost due to the short maturity of these instruments. Cash, receivable for investments sold and payable for investments purchased -- The carrying amount approximates fair value because of the short maturity of these instruments. Investments in unconsolidated affiliates -- The carrying amount is fair value due to accounting for these investments on the equity basis. Deferred premium revenue, net of prepaid reinsurance premiums -- The carrying amount of deferred premium revenue, net of prepaid reinsurance premiums, represents the Company's future premium revenue, net of reinsurance, on policies where the premium was received at the inception of the insurance contract. The fair value of deferred premium revenue, net of prepaid reinsurance premiums, is an estimate of the 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. Installment premiums -- Consistent with industry practice, there is no carrying amount for installment premiums since the Company will receive premiums on an installment basis over the term of the insurance contract. Similar to deferred premium revenue, the fair value of installment premiums is the estimated present value of the future contractual premium revenues 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 premium retained by the Company to compensate it for originating and servicing the insurance contract. Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses -- The carrying amount is fair value, which is the present value of the expected cash flows for specifically identified claims and potential losses in the Company's insured portfolio. December 31, 1998 December 31, 1997 ----------------- ----------------- (In thousands) Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value ------ ---------- ------ ---------- Assets: Bonds $1,708,040 $1,708,040 $1,268,158 $1,268,158 Short-term investments 98,554 98,554 132,931 132,931 Cash 3,490 3,490 12,475 12,475 Receivable for securities sold 1,655 1,655 20,623 20,623 Investment in unconsolidated affiliates 29,496 29,496 -- -- Liabilities: Deferred premium revenue, net of prepaid reinsurance premiums 504,603 417,130 422,073 347,855 Losses and loss adjustment expenses, net of reinsurance recoverable on unpaid losses 60,040 60,040 44,799 44,799 Notes payable 230,000 232,736 130,000 131,612 Payable for investments purchased 105,859 105,859 72,979 72,979 Off-balance-sheet instruments: Installment premiums -- 163,239 -- 116,888 22
16. LIABILITY FOR LOSSES AND LOSS ADJUSTMENT EXPENSES The Company's liability for losses and loss adjustment expenses consists of the case basis and general reserves. Activity in the liability for losses and loss adjustment expenses is summarized as follows (in thousands): Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- Balance at January 1 $ 75,417 $ 72,079 $111,759 Less reinsurance recoverable 30,618 29,875 61,532 -------- -------- -------- Net balance at January 1 44,799 42,204 50,227 Incurred losses and loss adjustment expenses: Current year 8,049 5,400 5,300 Prior years (4,100) 3,756 1,574 Recovered (paid) losses and loss adjustment expenses: Current year (192) (2,850) -- Prior years 11,484 (3,711) (14,897) -------- -------- -------- Net balance December 31 60,040 44,799 42,204 Plus reinsurance recoverable 3,907 30,618 29,875 -------- -------- -------- Balance at December 31 $ 63,947 $ 75,417 $ 72,079 ======== ======== ======== During 1996, the Company increased its general reserve by $6,874,000, of which $5,300,000 was for originations of new business and $1,574,000 was to reestablish a portion of the general reserve that had previously been transferred to case basis reserves. During 1996, the Company transferred $9,012,000 from its general reserve to case basis reserves associated predominantly with certain residential mortgage and timeshare receivables transactions. Giving effect to these transfers, the general reserve totaled $29,660,000 at December 31, 1996. During 1997, the Company increased its general reserve by $9,156,000, of which $5,400,000 was for originations of new business and $3,756,000 was to reestablish a portion of the general reserve that had previously been transferred to case basis reserves. During 1997, the Company transferred $4,503,000 from its general reserve to case basis reserves associated predominantly with certain residential mortgage transactions. Giving effect to these transfers, the general reserve totaled $34,313,000 at December 31, 1997. During 1998, the Company increased its general reserve by $3,949,000, of which $8,049,000 was for originations of new business offset by a $4,100,000 decrease in the amount needed to fund the general loss reserve because of recoveries on certain commercial mortgage transactions. During 1998, the Company transferred $18,403,000 to its general reserve from case basis reserves due to those recoveries on commercial mortgage transactions. Also during 1998, the Company transferred $9,414,000 from its general reserve to case basis reserves associated predominantly with certain consumer receivable transactions. Giving effect to these transfers, the general reserve totaled $47,251,000 at December 31, 1998. Reserves for losses and loss adjustment expenses are discounted at risk-free rates for the general reserve and for the case basis reserves at rates between 5.5% and 6.1%. The amount of discount taken was approximately $16,029,000, $19,779,000 and $17,944,000 at December 31, 1998, 1997 and 1996, respectively. 23
17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) (1) (In thousands, except share data) First Second Third Fourth Full Year ----- ------ ----- ------ --------- 1998 Gross premiums written $54,338 $89,242 $77,024 $98,662 $319,266 Net premiums written 37,947 62,121 54,462 65,323 219,853 Net premiums earned 31,921 32,452 32,618 40,936 137,927 Net investment income 18,683 19,255 19,710 21,175 78,823 Losses and loss adjustment expenses 1,047 1,047 1,046 809 3,949 Income before taxes 32,817 36,184 48,016 40,234 157,251 Net income 24,314 26,739 34,604 29,699 115,356 Basic earnings per common share 0.84 0.92 1.20 1.00 3.96 Diluted earnings per common share 0.81 0.88 1.15 0.96 3.77 1997 Gross premiums written $41,111 $90,995 $42,470 $61,815 $236,391 Net premiums written 27,184 67,495 28,911 49,288 172,878 Net premiums earned 24,774 27,561 27,204 29,972 109,511 Net investment income 16,361 17,121 17,920 20,683 72,085 Losses and loss adjustment expenses 2,285 2,156 2,426 2,289 9,156 Income before taxes 27,054 31,517 31,680 39,297 129,548 Net income 20,113 22,931 23,183 28,457 94,684 Basic earnings per common share 0.67 0.76 0.77 0.95 3.16 Diluted earnings per common share 0.65 0.75 0.75 0.92 3.06 (1) See Note 2 regarding the restatement of the financial statements relating to the accounting for the forward share purchase agreements. The effect of the restatement was to (decrease) increase the amounts previously reported as shown: - -------------------------------------------------------------------------------- (in thousands, except share data) 1998 First Second Third Fourth - -------------------------------------------------------------------------------- Income before taxes ($3,277) ($2,019) $5,566 ($2,765) - -------------------------------------------------------------------------------- Net income (2,130) (1,313) 3,618 (1,797) - -------------------------------------------------------------------------------- Basic earnings per common share (.07) (.05) .12 (.06) - -------------------------------------------------------------------------------- Diluted earnings per common share (.07) (.04) .12 (.06) - -------------------------------------------------------------------------------- 1997 First Second Third Fourth - -------------------------------------------------------------------------------- Income before taxes ($213) (3,540) (6,218) 1,020 - -------------------------------------------------------------------------------- Net income (138) (2,301) (4,041) 663 - -------------------------------------------------------------------------------- Basic earnings per common share - (.08) (.14) .02 - -------------------------------------------------------------------------------- Diluted earnings per common share (.01) (.07) (.13) .02 - -------------------------------------------------------------------------------- 18. EARNINGS PER SHARE In 1997, the Company adopted SFAS No. 128 specifying the computation, presentation and disclosure requirements for EPS. The new standard defines "basic" and "diluted" earnings per share. Basic earnings per share are based on average basic shares outstanding, which is calculated by adding shares earned but not issued under the Company's equity bonus and performance share programs to the average common shares outstanding. Diluted earnings per share are based on average diluted shares outstanding, which is calculated by adding shares contingently issuable under stock options, the performance share program and the Company's redeemable preferred stock to the average basic shares outstanding. The calculations of average basic and diluted common shares outstanding are as follows (in thousands): 24
Year Ended December 31, ----------------------- 1998 1997 1996 ---- ---- ---- Average common shares outstanding 28,854 29,858 30,547 Shares earned but unissued under stock-based compensation plans 248 170 80 ------ ------ ------ Average basic common shares outstanding 29,102 30,028 30,627 Shares contingently issuable under: Stock-based compensation plans 622 395 268 Redeemable preferred stock 875 490 -- ------ ------ ------ Average diluted common shares outstanding 30,599 30,913 30,895 19. RECENTLY ISSUED ACCOUNTING STANDARD In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 133 is effective January 1, 2000. The Company is in the process of determining the effect of these standards on its financial statements, but management does not believe that it will have a material effect on the Company's financial condition. 20. INVESTMENTS IN UNCONSOLIDATED AFFILIATES The Company accounts for investments in two companies on the equity basis. In June 1998, the Company invested $10,000,000 to purchase a 25% interest in Fairbanks Capital Holding Corp., which buys, sells and services residential mortgages. In November 1998, the Company invested $19,900,000 to purchase a 19.9% interest in XL Financial Assurance Ltd, a financial guaranty insurance subsidiary of XL (see Note 7). In 1998, the Company recognized equity losses of $548,000 and goodwill amortization of $240,000 on its Fairbanks Capital Holding Corp. investment and equity income of $332,000 on its XL Financial Assurance Ltd investment. 21. MINORITY INTEREST IN SUBSIDIARY In November 1998, the Company sold to XL, for $20,000,000, a 20% interest in Financial Security Assurance International Ltd., FSA's newly formed Bermuda-based financial guaranty subsidiary (see Note 7). This interest is in the form of Cumulative Participating Voting Preferred Shares, which in total have a minimum fixed dividend of $1,000,000 per annum. For the period ended December 31, 1998, the Company recognized minority interest of $388,000. 25