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| SCA > SEC Filings for SCA > Form 10-Q on 12-May-2008 | All Recent SEC Filings |
12-May-2008
Quarterly Report
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the related notes thereto contained in our unaudited interim consolidated financial statements included in this Form 10-Q for the three months ended March 31, 2008. This discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below. See also "Cautionary Note Regarding Forward-Looking Statements" for a list of factors that could cause actual results to differ materially from those contained in any forward-looking statement.
Overview of Our Business
General
Security Capital Assurance Ltd ("SCA") is a Bermuda-domiciled holding company whose operating subsidiaries provide credit enhancement and protection products to the public finance and structured finance markets throughout the United States and internationally. Its operating subsidiaries consist of XL Capital Assurance, Inc. ("XLCA") and its wholly owned subsidiary XL Capital Assurance (U.K.) Limited ("XLCA-UK") and XL Capital Financial Assurance Ltd. ("XLFA"). References to the "Company," "we," "us" and "our" mean SCA and, unless otherwise indicated, its subsidiaries.
Since our inception, we provided credit enhancement and protection through the issuance of financial guarantee insurance policies and credit default swap ("CDS") contracts, as well as the reinsurance of financial guarantee insurance and CDS contracts written by other insurers.
Financial guarantee insurance provides an unconditional and irrevocable guarantee to the holder of a debt obligation of full and timely payment of the guaranteed principal and interest. In the event of a default under the obligation, the insurer has recourse against the issuer or any related collateral (which is more common in the case of insured asset-backed obligations or other non- municipal debt) for amounts paid under the terms of the policy. CDS contracts are derivative contracts that offer credit protection relating to a particular security or pools of specified securities. Under the terms of a CDS contract, the seller of credit protection makes a specified payment to the buyer of credit protection upon the occurrence of one or more specified credit events with respect to a referenced security. Our financial guarantee reinsurance provides a means by which financial guarantee insurance companies can manage and mitigate risks in their in-force business and/or increase their capacity to write such business.
Adverse developments in the credit markets generally and the mortgage market in particular in the second half of 2007 that rapidly accelerated in the fourth quarter of 2007 and continued to deteriorate in the first quarter of 2008 have had, and continue to have, a material adverse impact on our insured portfolio and our business, results of operations and financial condition. These adverse developments have resulted from many factors, including a broad deterioration in the quality of credit, increasing credit spreads across most bond sectors and significantly higher rates of delinquency, foreclosure and loss in residential mortgage loans. These developments have caused us to record significant reserves for unpaid losses and loss adjustment expenses on our insured residential mortgage-backed securities ("RMBS"), as well as the recognition of significant unrealized losses on our credit derivative guarantees of collateralized debt obligations ("CDOs") of asset- backed securities ("ABS CDOs") (which include significant impairment relating to anticipated claims) in the fourth quarter of 2007 followed by further incremental provisions for reserves and unrealized losses in the first quarter of 2008.
Until recently, we had maintained triple-A ratings from Moody's Investors Services, Inc. ("Moody's"), Fitch Ratings ("Fitch"), and Standard and Poor's Ratings Services ("S&P") and these ratings have been fundamental to our historical business plan and business activities. However, in response to the deteriorating market conditions, the rating agencies have updated their analyses and evaluations of the financial guarantee insurance industry including us and our operating subsidiaries, XLCA and XLFA. As a result, our insurance financial strength ("IFS") ratings have been downgraded by the rating agencies and the rating agencies have placed our IFS ratings on creditwatch/ratings watch negative or on review for
Ratings Downgrades and Other Actions
Each of Moody's, Fitch and S&P has reassessed our historical triple-A ratings in
light of recent market conditions resulting in downgrades and continued
monitoring. On February 25, 2008, S&P downgraded the IFS, credit enhancement and
issuer credit ratings of XLCA, XLCA-UK and XLFA to "A-" from "AAA" and each
remains on CreditWatch with negative implications. S&P stated that under its
capital adequacy model, XLCA's, XLCA-UK's and XLFA's margin of safety falls in
the "A" category and the CreditWatch Negative designation reflects potential
that our strategic plan may not be successful. S&P also announced on that date
that under its updated theoretic bond insurance stress case scenario, XLCA's and
XLFA's total after-tax net loss on their guarantees of RMBS and CDOs are
estimated by it to be approximately $2.8 billion, which, we believe, would
result in a capital shortfall of approximately $1.8 billion at S&P's "AAA"
ratings level. On March 4, 2008, Moody's placed the "A3" IFS ratings of XLCA,
XLCA-UK and XLFA on review for possible downgrade. Previously, on February 7,
2008, Moody's downgraded the IFS rating of XLCA, XLCA-UK and XLFA to "A3"
(Negative Outlook) from "Aaa" at which time Moody's noted that, under its
analysis, the capitalization required to cover losses at the "Aaa" target level
would exceed $6 billion compared to Moody's estimate of SCA's current claims
paying resources of $3.6 billion. On March 26, 2008, Fitch downgraded the IFS
rating of XLCA, XLCA-UK and XLFA to "BB" (Rating Outlook Negative) from "A"
(Rating Watch Negative). Fitch noted that SCA's then current claims paying
resources fall below the targeted IFS rating ranges by the following amounts:
"AAA" capital shortfall of $5.6 to $5.9 billion; "AA" capital shortfall of $3.9
to $4.5 billion; "A" capital shortfall of $1.3 to $2.5 billion; and "BBB"
capital shortfall of $600 million to $1.2 billion. Previously, on January 23,
2008, Fitch had downgraded the IFS ratings of XLCA, XLCA-UK and XLFA to "A"
(Rating Watch Negative) from "AAA." In addition to these downgrades of our IFS
ratings, Moody's, S&P and Fitch have also downgraded our debt and other ratings.
These rating agency actions reflect Moody's, S&P's and Fitch's current assessment of our creditworthiness, business franchise and claims-paying ability. This assessment reflects our exposures to the U.S. residential mortgage market, which has precipitated our weakened financial position and business profile based on increased reserves for losses and loss adjustment expenses, realized and unrealized losses on credit derivatives and modeled capital shortfalls. The ratings downgrades also reflect the ratings agencies' views with respect to our franchise, business model and strategic direction, uncertain capital markets and the impact of our business decisions on future financial flexibility, our future capital strategy and ability to raise additional capital, ultimate loss levels in our insured portfolio, and the recent challenges in the financial guarantee market overall.
Under the various rating agency models, there are significant shortfalls in our capital position for a triple-A rating. The ratings agencies have announced that in order to regain our triple-A ratings, we would need to address this capital shortfall. This may include raising significant new capital or generating rating agency capital and additional claims-paying resources through the run-off of existing business and generation of future earnings therefrom. It is uncertain whether addressing the capital shortfalls identified by the rating agencies will result on its own in a restoration of our triple-A ratings.
Review of Strategic Options
As a result of the recent developments discussed above, our Board of Directors retained Goldman Sachs & Co. as financial advisors to assist us in evaluating strategic alternatives, including raising new capital, structuring reinsurance solutions and negotiating the commutation or restructuring of certain of our financial guarantee obligations. We have also engaged Rothschild, Inc. to assist us with a comprehensive review of all strategic and reorganization options. We have been exploring various strategic options with our advisors and potential investors and counterparties and in consultation with our regulators to preserve and potentially enhance our capital resources, address the rating agencies' requirements, and eventually restore our ratings to a level sufficient to permit us to recommence writing new business, which we believe to be the equivalent of a "AA" rating by S&P. However, we cannot provide any assurance that we can successfully address the rating agencies' requirements or when, and if, we will be able to recommence writing new business.
• suspending the writing of substantially all new business; as our in-force business runs-off or matures, capital that currently supports such business and, accordingly, is not otherwise currently available to be used by us, should become available and enhance our ability to comply with regulatory risk limits and rating agency capital requirements absent deterioration or other changes in our insured portfolio. However, we do not believe that this action by itself will generate capital in the near term which would be sufficient to qualify for the equivalent of a "AA" rating by S&P;
• pursuing commutation, restructuring or settlement of our guarantees, particularly with our CDO counterparties, in order to mitigate uncertainty in regard to adverse development of reserves for unpaid losses and anticipated claims and generate available capital;
• exploring the commutation of assumed reinsurance agreements or entering into new ceded reinsurance agreements to reduce the capital that we are required to maintain in support of our ratings by rating agencies;
• exploring with XL Capital Ltd ("XL Capital") the commutation or settlement of obligations and contingent obligations due to us for fair value, including: (i) the XL Insurance (Bermuda) Ltd ("XLI"), an indirect wholly owned subsidiary of XL Capital, guarantee of XLFA's pre-initial public offering ("IPO") obligations to XLCA under a reinsurance agreement and (ii) an excess of loss reinsurance agreement between XLI and XLFA;
• continuing to realign our cost structure to reflect current business conditions;
• seeking to raise new capital from third parties under more favorable market conditions than exist at the present time; and
• continuing to investigate longer term strategic alternatives, including the restructuring of our business to facilitate the creation or raising of new capital.
We continue to pursue the execution of this plan. To date our progress on this plan is as follows: we have formed a bank group to discuss commutation, restructuring or settlement of our guarantees; we have undertaken discussions with XL Capital for commutation or settlement of obligations and contingent obligations due to us; we have reduced staff by approximately 60 positions (see note 14(d) to the unaudited interim consolidated financial statements); and we continue to have discussions with third-party investors.
There can be no assurance that our strategic plan will not evolve or change over time, will be successfully implemented in whole or in part or when and if it will address the requirements of the rating agencies. In addition, there can be no assurance that we will be able to recommence writing new business in the near term or at all. If we are unable to successfully execute our strategic plan, it will have a material adverse effect on our financial condition and results of operations. See "Item 1A. Risk Factors-Risks Related to our Company" in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (the "SEC") on March 17, 2008 (our "Annual Report on Form 10-K").
Recent Regulatory Developments
On April 11, 2008, XLFA entered into an undertaking with the Bermuda Monetary Authority ("BMA") pursuant to which XLFA agreed to consult with the BMA (providing at least ten business days' prior notice) before (i) declaring and/or paying any dividend, (ii) distributing any statutory capital, (iii) entering into any intercompany loans or guarantees, (iv) entering into any contracts of insurance or reinsurance and (v) entering into any restructuring or other related transaction to which XLFA is a party. XLFA acknowledged and agreed that there is no assurance the BMA would not object to or block any proposed action presented to it and XLFA agreed not to proceed if the BMA objects to or seeks to block such action.
We continue to consult frequently with our primary regulators, including the New York Insurance Department, the BMA and the Financial Services Authority of the United Kingdom about our capital resources and strategic plan and our timetable for our efforts to implement our strategic plan.
On April 3, 2008, we received notification from the New York Stock Exchange ("NYSE") advising us that the we were not in compliance with a NYSE continued listing standard applicable to our common shares. On April 8, 2008, we notified the NYSE that it is our intention to cure this deficiency and maintain our listing.
Termination of CDS Contracts
On February 22, 2008 and March 6, 2008, we issued notices terminating seven CDS contracts (the "ML CDS Contracts") with Merrill Lynch International ("MLI") under which we had agreed to make payments to MLI on the occurrence of certain credit events pertaining to particular ABS CDOs referenced in the ML CDS Contracts. We issued each of the termination notices on the basis of MLI's repudiation of certain contractual obligations under each of the ML CDS Contracts. On March 19, 2008, MLI filed a complaint in a New York federal court challenging the effectiveness of our terminations. On March 31, 2008, we filed a counterclaim seeking a judgment from the court that its terminations were effective and an award of damages for MLI's failure to make certain termination payments under the ML CDS Contracts. On April 18, 2008, MLI filed a motion for summary judgment which we will oppose and which is scheduled to be argued to the court on June 4, 2008. The court has also entered a scheduling order under which the case will be ready for trial in September 2008. The notional amount of the ML CDS Contracts at March 31, 2008 and December 31, 2007 aggregated $3.1 billion before the effect of credit derivatives we purchased to offset such exposure ($3.0 billion after such offsetting credit derivatives). During the fourth quarter of 2007, we recorded a charge of $632.3 million relating to the ML CDS Contracts which, under the revised financial statement presentation for CDS contracts discussed in note 3 to the unaudited interim consolidated financial statements, will be reflected, upon the representation of such results, in the "Unrealized gains and losses" component of the "Net change in fair value of credit derivatives" reported in our statement of operations. For three months ended March 31, 2008, we recorded an unrealized gain of $532.6 million relating to the ML CDS Contracts. The change in the fair value of the ML CDS Contracts during the three months ended March 31, 2008 is primarily attributable to the adoption of Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" ("SFAS 157"), which requires that the valuation of our derivative liabilities reflect our risk of non-performance. This risk is measured by reference to the cost of buying credit protection on XLCA. See "-Critical Accounting Policies and Estimates-Valuation of Derivative Financial Instruments" and note 4 to the unaudited interim consolidated financial statements. At March 31, 2008 and December 31, 2007 we carried derivative liabilities relating to the ML CDS Contracts aggregating $162.8 million and $721.5 million, respectively, and derivative assets from purchased credit derivatives offsetting such exposures of $63.1 million and $89.2 million, respectively. Also, at March 31, 2008 and December 31, 2007, management's best estimate of anticipated claims and recoveries on the ML CDS Contracts, net of any recoveries anticipated from purchased credit derivatives, was $428.9 million and $417.3 million, respectively. There was no change in anticipated claims and recoveries or recoveries from purchased credit derivatives on the ML CDS Contracts offsetting such exposures during the three months ended March 31, 2008 other than that related to the accretion associated with the present value discount of such anticipated claims and recoveries.
Other Matters
In early 2008 we put in place a reinsurance agreement between XLCA and XLFA, which is intended to mitigate the adverse effects on XLCA's equity, as determined in accordance with accounting principles generally accepted in the United States of America ("GAAP"), from the change in fair value of XLCA's CDS contracts. See "-Critical Accounting Policies and Estimates-Valuation of Derivative Financial Instruments" and note 4 to the unaudited interim consolidated financial statements. In addition, in late
Organization Background, Initial Public Offering, and Ownership by XL Capital
We were formed as an indirect wholly-owned Bermuda-based subsidiary of XL Capital on March 17, 2006. On July 1, 2006, XL Capital contributed all its ownership interests in its financial guarantee insurance and financial guarantee reinsurance operating businesses to us. These businesses consisted of: (i) XLCA and its wholly-owned subsidiary, XLCA-UK and (ii) XLFA. XLCA was an indirect wholly owned subsidiary of XL Capital and all of XLFA was owned by XL Capital except for a preferred stock interest which is owned by Financial Security Assurance Holdings Ltd. ("FSAH"), an entity which is otherwise not related to XL Capital or us. On August 4, 2006, we completed our IPO from which we received net proceeds of $341.3 million. We contributed $298.1 million of the proceeds to XLFA and $25.0 million to XLCA to support their business operations and retained $18.2 million for general corporate purposes. In addition, XL Capital sold a portion of its shares in the IPO reducing its ownership to approximately 63% economic interest in SCA, adjusted for restricted share awards to our employees and management made at the effective date of the IPO. In June 2007, XL Capital sold an additional 10,627,422 common shares of SCA further reducing its ownership to approximately 46% voting and economic interest in SCA, adjusted for restricted share awards to our employees and management outstanding as of such date. XL Capital's voting interest in SCA is subject to limitations contained in our bye-laws if XL Capital's voting interest exceeds a certain percentage of our shares; however, since XL Capital has reduced their holdings, this limitation is not currently in effect.
Key Factors Affecting Profitability
Impact of Economic Cycles
The financial guarantee business is significantly affected by economic cycles. For example, a robust economy featuring a good or improving credit environment is beneficial to the in-force portfolios of financial guarantee insurers and reinsurers. Historically, however, when such conditions have existed for an extended period, credit spreads tend to narrow and pricing and demand for financial guarantee insurance and reinsurance tend to decline. A weakening economic and credit environment, in contrast, is typically marked by widening credit spreads and increasing pricing for financial guarantee products. However, a prolonged period of weak or declining economic activity could stress in-force financial guarantee insured portfolios and result in claims or could adversely impact capital adequacy due to deterioration in the credit quality of in-force insured portfolios.
Over the past several quarters, credit spreads across most bond sectors have widened reflecting widely published concerns in regard to potential credit erosion in the U.S. residential mortgage and corporate credit sectors. This trend has affected, or could affect, many companies such as ours which have exposure to the securities which have been issued over the years to finance the housing industry, such as RMBS and ABS CDOs. Specifically, in the current environment, transactions within our insured RMBS and ABS CDO portfolios have been or may be downgraded, placed on watch or subject to other actions by the three rating agencies. Such ratings actions could in turn require us to maintain a material amount of additional capital to support the exposures we have guaranteed. Among other things, this could cause us to: (i) have to raise additional capital, if available, on terms, and under conditions, that may be unfavorable which among other things could increase our cost of capital, (ii) curtail the production of new business, or (iii) pay to reinsure or otherwise transfer certain of our risk exposure. See "-Overview of Our Business-General-Review of Strategic Options" above.
See also "-Exposure to Residential Mortgage Market" below for additional information in regard to our exposure to residential mortgages, "-Critical Accounting Policies and Estimates-Valuation of Derivative Financial Instruments" for information in regard to how our GAAP earnings are affected by the change in the fair value of our credit derivatives and "Item 1A. Risk Factors-Risks Related to Our Company" in our Annual Report on Form 10-K.
Components of Our Revenues
We derive our revenues principally from: (i) premiums from our insurance and reinsurance businesses, (ii) net investment income and net realized gains and losses from our investment portfolio
Our premiums are a function of the amount of par or notional amount of debt obligations that we guarantee, market prices and the type of debt obligation guaranteed. We receive premiums either on an upfront basis when the policy is issued or the contract is executed, or on an installment basis over the life of the applicable transaction.
Premiums are accounted for as written when due; therefore, when we enter into policies that provide for upfront premium, all of the premium on the policy is accounted for as written generally when the policy commences. The portion of the upfront premium that has been written but has not yet been earned is carried on our balance sheet as deferred premium revenue. When we enter into policies that provide for installment premium, only that installment of the premium that is then due (generally the current monthly, quarterly or semiannual installment) is accounted for as written. Future premium installments during the remainder of the life of the installment-based policy are not reflected on our financial statements. Therefore, the amount of total premiums written that we report for any period will be affected by the mix of policies that we wrote in that period on an "upfront" and, in that period and prior periods, on an "installment" basis. Generally, a financial guarantee insurance company with a growing in-force book of business should recognize an increasing amount of net earned premium from policies written in prior reporting periods, whether premiums are received on an upfront or installment basis. Future installments of premium on business written in a period are reported by financial guarantors as a component of adjusted gross premiums, a non-GAAP financial measure. See "-Other Measures Used by Management to Evaluate Operating Performance" for additional information. The amount of installment premiums actually realized by us in the future (and that would be otherwise reflected in revenue) could be reduced due to factors such as early termination of insurance contracts or accelerated prepayments of underlying obligations.
Our investment income is a function of the amount of our invested assets and the yield that we earn on those assets. The investment yield will be a function of market interest rates at the time of investment, as well as the type, credit quality and duration of our invested assets. In addition, we could realize gains or losses on the sale of securities in our investment portfolio or recognize an other-than-temporary impairment as a result of changing market conditions, including changes in market interest rates, and changes in the credit quality of our invested assets.
The change in fair value of our credit derivatives is primarily based on changes in credit spreads, the credit quality of the referenced securities, rates of return and various other factors. See "-Critical Accounting Policies and Estimates-Valuation of Derivative Financial Instruments" and note 4 to our unaudited interim consolidated financial statements for additional information.
Components of Our Expenses
Our expenses primarily consist of losses and loss adjustment expenses, acquisition costs, and operating expenses. Acquisition costs are related to the production of new financial guarantee insurance business and commissions paid on reinsurance assumed, net of commission revenues earned on ceded business. These costs are generally deferred and recognized over the period in which the related premiums are earned. Operating expenses consist primarily of costs relating to compensation of our employees, information technology, office premises, and professional fees.
Other Measures Used by Management to Evaluate Operating Performance
The following are certain financial measures management considers important in evaluating our operating performance:
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