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AGO > SEC Filings for AGO > Form 10-K/A on 31-Oct-2011All Recent SEC Filings

Show all filings for ASSURED GUARANTY LTD

Form 10-K/A for ASSURED GUARANTY LTD


31-Oct-2011

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of the Company's financial condition and results of operations should be read in conjunction with the Company's consolidated financial statements and accompanying notes which appear elsewhere in this Form 10-K/A. It contains forward looking statements that involve risks and uncertainties. Please see "Forward Looking Statements" for more information. The Company's actual results could differ materially from those anticipated in these forward looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K/A, particularly under the heading "Forward Looking Statements" and the Original Form 10-K under the heading "Risk Factors."

Introduction

Assured Guaranty provides, through its operating subsidiaries, credit protection products to the U.S. and international public finance, infrastructure and structured finance markets. The Company has applied its credit underwriting judgment, risk management skills and capital markets experience to develop insurance, reinsurance and credit derivative products that protect holders of debt instruments and other monetary obligations from defaults in scheduled payments, including scheduled interest and principal payments. The securities insured by the Company include taxable and tax-exempt obligations issued by U.S. state or municipal governmental authorities, utility districts or facilities; notes or bonds issued to finance international infrastructure projects; and asset-backed securities issued by special purpose entities. The Company markets its credit protection products directly to issuers and underwriters of public finance, infrastructure and structured finance securities as well as to investors in such debt obligations. The Company guarantees debt obligations issued in many countries, although its principal focus is on the U.S., Europe and Australia. The Company's business segments are comprised of two principal segments based on whether the contracts were written on a direct or assumed basis.

Financial guaranty contracts written in insurance form provide an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due. Financial guaranty contracts written in credit derivatives form are generally structured such that the circumstances giving rise to the Company's obligation to make loss payments are similar to those for financial guaranty contracts accounted for as insurance and only occurs upon one or more defined credit events with respect to one or more third party referenced securities or loans. Financial guaranties accounted for as credit derivatives are primarily comprised of credit default swap ("CDS").

Public finance obligations insured or assumed through reinsurance by the Company consist primarily of general obligation bonds supported by the issuers' taxing powers, tax-supported bonds and revenue bonds and other obligations of states, their political subdivisions and other municipal issuers supported by the issuers' or obligors' covenant to impose and collect fees and charges for public services or specific projects. Public finance obligations include obligations backed by the cash flow from leases or other revenues from projects serving substantial public purposes, including government office buildings, toll roads, health care facilities and utilities.

Structured finance obligations insured or assumed through reinsurance by the Company 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 and issued by special purpose entities. The Company currently does not underwrite U.S. residential mortgage-backed securities ("RMBS").

2010 Executive Summary

This executive summary of management's discussion and analysis highlights selected information and may not contain all of the information that is important to readers of the Annual Report. For a complete description of events, trends and uncertainties, as well as the capital, liquidity, credit, operational and market risks and the critical accounting policies and estimates affecting the Company, the Original Form 10-K and this Form 10-K/A should be read together in their entirety. Financial information in Management's Discussion and Analysis has been restated as described in Note 2 of "Item 8. Financial Statements and Supplementary Data." The restatement related primarily to the correction of errors in the elimination of intercompany transactions between the Company's insurance


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subsidiaries and the consolidated financial guaranty variable interest entities ("VIEs"). The restatement resulted in a decrease to net income of $55.2 million in 2010 and a decrease to net income of $11.2 million in 2009 from amounts previously reported in the Original Form 10-K.

Financial Performance

The most significant contributing factor to increases in most of the major components of revenue and expense lines items in 2010 was the inclusion of a full year of AGMH results of operation in 2010 compared with only six months in 2009, as described below. In addition to AGMH's full year contribution to income in 2010, income was positively affected by commutation gains of $49.8 million related to several AGMH ceded reinsurance contracts, and a net tax benefit of $55.8 million due to the filing of an amended tax return for a period prior to the AGMH Acquisition.

In 2010, loss and LAE on financial guaranty contracts accounted for as insurance and losses incurred on credit derivatives (i.e., claim payments plus changes in future expected losses on credit derivatives) were higher than 2009 due primarily to higher U.S. RMBS losses. The changes in assumptions in 2010
(a) reflect a slower recovery in the housing market than had been assumed at the beginning of the year, and (b) include an increase in the assumed initial loss severities for subprime transactions from 70% to 80%. Mitigating the effects of this loss development were increases in the benefit taken for recoveries from breaches of representations and warranties ("R&W"), as the Company's loss mitigation efforts have been increasingly successful in obtaining commitments to repurchase and accessing new loan files.

Credit spreads of underlying CDS obligations and the Company's own credit spreads can have a significant effect on reported net income. In 2010, Alt-A option ARMs and Alt-A first lien transactions generated fair value losses due to wider implied net spreads. This was offset in part by fair value gains in the pooled corporate and other sectors which had tighter implied spreads.

The adoption of a new consolidation model for VIEs on January 1, 2010 affects comparability between 2010 and 2009. On that date, 21 VIEs were consolidated and four were deconsolidated, and throughout 2010, additional VIEs were consolidated and others were deconsolidated. As of December 31, 2010, the Company had consolidated 29 VIEs. In 2010, the Company consolidated VIEs when it had both 1) the power to direct the activities of a VIE that most significantly impact the entity's economic performance; and 2) the obligation to absorb losses of the entity that could potentially be significant to the VIE or the right to receive benefits from the entity that could potentially be significant to the VIE. The Company continuously evaluates its power to direct the activities that most significantly impact the economic performance of VIEs that have debt obligations insured by the Company. The Company obtains protective rights under its insurance contracts that give the Company additional controls over a VIE if there is either deterioration of deal performance or in the financial health of the deal servicer. Under accounting principles generally accepted in the United States of America ("GAAP"), the Company is deemed to be the control party typically when its protective rights give it the power to both terminate and replace the deal servicer.

The Company elected the fair value option for all newly consolidated financial guaranty VIEs in 2010, which required that changes in fair value be recorded in the consolidated statements of operations. Consistent with consolidation accounting rules, in 2010, net earned premium of $47.6 million and loss and LAE of $65.9 million associated with consolidated VIEs were eliminated from the reported results of operations. The discussion of each affected revenue and expense line item below describes the financial effect in 2010 of this new accounting model.


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                             Financial Performance

                                                     Year Ended December 31,
                                               2010             2009          Change
                                                 (dollars in millions, except per
                                                          share amounts)
                                            (restated)       (restated)     (restated)
Net earned premiums                         $    1,186.7     $     930.4    $     256.3
Net investment income                              354.7           259.2           95.5
Realized gains and other settlements on
credit derivatives                                 153.5           163.6          (10.1 )
Net unrealized gains (losses) on credit
derivatives                                       (155.1 )        (337.8 )        182.7
Net change in financial guaranty VIEs             (273.6 )          (1.2 )       (272.4 )
Loss and LAE                                      (412.2 )        (393.8 )        (18.4 )
AGMH Acquisition-related expenses                   (6.8 )         (92.3 )         85.5
Goodwill and settlement of pre-existing
relationship                                           -           (23.3 )         23.3
Other operating expenses                          (211.5 )        (174.1 )        (37.4 )
Net income (loss) attributable to
Assured Guaranty Ltd.                              493.7            86.0          407.7
Diluted earnings per share                          2.61            0.66           1.95

The table above presents selected financial data in accordance with GAAP. In addition to these measures, the Company evaluates several non-GAAP financial measures which are described in "-Non-GAAP Financial Measures." One such measure is PVP as described below.

The tables below present new business production ("PVP") and par amount written in the period. The gross PVP represents the present value of estimated future earnings primarily on new financial guaranty insurance and credit derivative contracts written in the period, before consideration of cessions to reinsurers. See "-Non-GAAP Financial Measures" for a detailed description of PVP.

                    Present Value of New Business Production

                                                      Year Ended
                                                     December 31,
                                                    2010      2009
                                                     (in millions)
                  Public finance-U.S.
                       Primary markets             $ 285.6   $ 557.1
                       Secondary markets              42.5      57.1
                  Public finance-non-U.S.
                       Primary markets                   -       1.6
                       Secondary markets               0.7       0.2
                  Structured finance-U.S.             30.2      23.2
                  Structured finance-non-U.S.          3.7       1.0

                       Total                       $ 362.7   $ 640.2


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                      Financial Guaranty Gross Par Written

                                               Year Ended December 31,
                                                2010             2009
                                                    (in millions)
           Public finance-U.S.
                Primary markets              $     26,195     $     45,793
                Secondary markets                   1,567            1,327
           Public finance-non-U.S.
                Primary markets                         -              466
                Secondary markets                      34               90
           Structured finance-U.S.                  2,963            2,245
           Structured finance-non-U.S.                  -                -

                Total                        $     30,759     $     49,921

PVP in 2010 decreased due to lower new business production in the new issue tax-exempt U.S. municipal market. During 2010, the Company insured, on a sales date basis, 1,697 U.S. new issue public finance transactions. The Company insured 8.4% of tax-exempt new issue par and 14.0% of tax-exempt new issue transactions originated in the U.S. public finance market during 2010. The decline in the Company's 2010 PVP reflects the decrease in insurable transactions as a result of the Build America Bonds ("BABs") program, rating recalibration and uncertainty about the Company's financial strength rating.

All par written since second quarter of 2009 has been in the direct segment and was primarily U.S. public finance business. In January 2009, Assured Guaranty Corp. ("AGC") finalized a reinsurance agreement with CIFG Assurance North America Inc. to assume a diversified portfolio of financial guaranty contracts totaling approximately $13.3 billion of net par outstanding which was included in the reinsurance segment. AGC received $75.6 million, net of ceding commissions, as of the closing of this transaction and it was entitled to approximately $12.2 million of future installments related to this transaction. There have been no PVP originations in the reinsurance segment since the first quarter of 2009.

The table below reconciles PVP to gross written premiums.

Reconciliation of PVP to Gross Written Premium

                                                                Year Ended
                                                               December 31,
                                                              2010      2009
                                                              (in millions)
       Total PVP                                            $  362.7   $ 640.2
         Less: PVP of credit derivatives                           -       2.4

       PVP of financial guaranty insurance                     362.7     637.8
         Less: Financial guaranty installment premium PVP       33.2      25.4

       Total: Financial guaranty upfront GWP                   329.5     612.4
         Plus: Financial guaranty installment GWP             (107.2 )   (55.1 )

       Total financial guaranty GWP                            222.3     557.3
         Plus: Other GWP                                           -      (0.9 )

       Total GWP                                            $  222.3   $ 556.4


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Business Overview

Since 2008, the Company has been the most active provider of financial guaranty credit protection products. The significant financial distress faced by many of the Company's former competitors since 2007, the Company's ability to maintain investment-grade financial strength ratings throughout the financial crisis, and its acquisition of AGMH in 2009 have all contributed to the Company's position in the market. However, business conditions have been difficult for the entire financial guaranty insurance industry since 2007 and the Company has faced challenges in maintaining its market penetration that continue today.

The recent U.S. economic recession that began in 2007 following the start of a global financial crisis was the longest recession the U.S. has experienced since World War II. The recession combined with the global financial crisis and, in some cases, highly leveraged financial risk, created significant credit and financial losses at many financial institutions, resulting in record levels of failures and government bailout of many global financial institutions and corporations.

Within the financial guaranty industry, financial losses were concentrated in the U.S. RMBS sector and, in particular, on collateralized debt obligations ("CDOs") backed by asset-backed securities ("ABS") containing significant residential mortgage collateral ("CDOs of ABS"). The Company has very limited exposure to CDOs of ABS, with only $32.3 million in net par outstanding as of December 31, 2010. As a result of credit losses on these types of securities, all of the Company's pre-2007 financial guaranty competitors, except Assured Guaranty Municipal Corp. ("AGM"), have had their financial strength ratings downgraded by rating agencies to below investment grade levels, rendering them unable to underwrite new business. The Company's insurance subsidiaries have also been downgraded, principally due to their exposure to U.S. RMBS, but because management substantially avoided insuring CDOs of ABS, AGM and AGC have retained double-A level ratings, which have been acceptable for new business origination.

Although the National Bureau of Economic Research declared that the recession ended in June 2009, housing prices have not consistently stabilized and the ultimate credit experience on U.S. RMBS transactions underwritten from the end of 2004 through 2008 by many financial institutions, including the financial guaranty insurers, remains uncertain. Furthermore, while hiring trends have improved, unemployment levels remain high and may take years to return to pre-recession levels, which may adversely affect Assured Guaranty's loss experience on RMBS. In addition, the economic recession has also affected the credit performance of other markets, including pooled corporate obligations insured by the Company and, more specifically, trust preferred securities ("TruPS") that include subordinated capital and notes issued by banks, mortgage real estate investment trusts and insurance companies.

The U.S. municipal bond market, which has been the Company's principal market since 2007, has also changed significantly during the past three years. Municipal credits have experienced increased budgetary stress, as the amount of sales, income and real estate taxes and other municipal excise or usage revenues collected by most states and municipalities have declined. In addition, many states and towns have significant unfunded pension and retiree health care liabilities that create additional budgetary stress.

The current economic environment has had a significant negative impact on the demand by investors for financial guaranty policies, and it is uncertain when or if demand for financial guaranties will return to their pre-economic crisis level. In particular, there has been limited demand for financial guaranties in 2010 in both the global structured finance and international infrastructure finance markets and also limited new issuance activity in those asset classes in which the Company was previously active. As a result, near-term opportunities for financial guaranties in these two sectors are largely in secondary markets. The Company expects that global structured finance and international infrastructure opportunities will increase in the future as the global economy recovers, issuers return to the capital markets for financings and institutional investors again utilize financial guaranties. Financial guaranties had been an essential component of capital markets financings for international infrastructure projects and asset-based lending, such as for auto loans and leases and equipment financings, but these financings have been largely financed in recent years with relatively short-term bank loans.


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With respect to the Company, during 2010, the Company faced challenges in maintaining its market penetration. The portion of the market that benefited from the Company's insurance product was reduced as a result of a combination of the rating agency recalibration and upgrading of the ratings of municipal bonds; the downgrade of AGC's financial strength rating by Moody's in November 2009; and the issuances under the BABs program that constituted a large volume of the transactions in the U.S. public finance market during the year. In addition, both the uncertainty over the financial strength ratings of the Company's insurance subsidiaries and a negative perception of financial guaranty insurers arising from the financial distress suffered by other companies in the industry during the financial crisis have resulted in lower demand for the Company's insurance product.

In 2010, the Company insured 6.2% of new U.S. municipal issuance based on par. The following table presents additional detail with respect to the Company's penetration into the U.S. public finance market in 2010, 2009 and 2008.

                             Municipal Market Data

                                                  Year Ended December 31,
                                   2010                    2009                    2008
                                       Number                  Number                  Number
                             Par      of issues      Par      of issues      Par      of issues
                                      (dollars in billions, except number of issues)
New municipal bonds
issued                     $ 430.8        13,594   $ 406.8        11,412   $ 386.5        10,452
New municipal bonds
issued under BABs
program                      117.3         1,567      64.2           784         -             -
New municipal bonds
insured (all financial
guaranty)                     26.8         1,697      35.4         2,012      72.2         2,564
New municipal bonds
insured (AGC and AGM)         26.8         1,697      34.8         2,005      65.7         2,415
New municipal bonds
insured under BABs
program (AGC and AGM)          4.7           153       1.7            87         -             -

Management believes that, in light of the prevalence of individual rather than institutional investors in the municipal market, the Company is able to provide value not only by insuring the timely payment of scheduled interest and principal amounts when due, but also through its underwriting skills and surveillance capabilities. Because few individual or even institutional investors have the analytic resources to cover all the varied municipal credits in the market, which are estimated to number more than 30,000, through its financial guaranty, the Company effectively consolidates the tasks of credit selection, analysis, negotiation of terms, monitoring and, if necessary, remediation. Management believes this allows retail investors to participate more widely, institutional investors to operate more efficiently and smaller, less well-known issuers to gain market access on a more cost-effective basis. In fact, in 2010, based on par, the Company insured approximately 15% of new U.S. municipal issuance in the single-A rating category, which is its target market, and more than 15% of new U.S. municipal issuance transactions that were $25 million or less in size.

Rating Agency Actions

When a rating agency rates a financial obligation guaranteed by one of AGL's insurance company subsidiaries, it generally awards that obligation the same rating it has assigned to the financial strength of the AGL subsidiary that provides the guaranty. Investors in products insured by the Company's insurance company subsidiaries frequently rely on ratings published by nationally recognized statistical rating organizations ("NRSROs") because such ratings influence the trading value of securities and form the basis for many institutions' investment guidelines as well as individuals' bond purchase decisions. Therefore, the Company manages its business with the goal of achieving high financial strength ratings. However, the models used by NRSROs differ, presenting conflicting goals that may make it inefficient or impractical to reach the highest rating level. The models are not fully transparent, contain subjective data (such as assumptions about future market demand for the Company's products) and change frequently. Ratings reflect only the views of the respective NRSROs and are subject to continuous review and revision or withdrawal at any time.


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On September 27, 2011, Standard and Poor's Rating Services ("S&P") published a Research Update in which it placed its ratings on Assured Guaranty on CreditWatch Negative. This action included changing the financial strength ratings of AGC and AGM from AA+ (Negative Outlook) to AA+ (CreditWatch Negative), and the AA (Negative Outlook) rating of AG Re to AA (CreditWatch Negative), signifying that S&P may downgrade such financial strength ratings in the near future. In the Research Update, S&P stated that the CreditWatch placement is due to significant concentration risk in Assured Guaranty's consolidated insured portfolio; the portfolio contains exposures that are not consistent with S&P's new bond insurance rating criteria and breach the "largest obligor test" in such new criteria. S&P published updated criteria in Bond Insurance Rating Methodology and Assumptions on August 25, 2011, subsequent to S&P's publication of Request for Comment: Bond Insurance Criteria on January 24, 2011. However, according to S&P, based on statements from Assured Guaranty's management that Assured Guaranty intends to take action to mitigate these concentration risks, it is likely such actions, if taken, would support financial strength ratings in the "AA" category. S&P noted that it expects to resolve this CreditWatch placement no later than November 30, 2011. If the Company were unable to mitigate the concentration risks by creating capital or utilizing additional forms of reinsurance on acceptable terms, S&P may downgrade the ratings of Assured Guaranty, including the financial strength ratings of AGC, AGM and AG Re. See Notes 6, 8 and 13 for the potential impact of a financial strength rating downgrade on the Company and on the insured portfolio.

AGMH Acquisition

On July 1, 2009 ("Acquisition Date"), the Company, through its wholly-owned subsidiary, Assured Guaranty US Holdings Inc. ("AGUS"), purchased AGMH (formerly Financial Security Assurance Holdings Ltd, the "AGMH Acquisition") and, indirectly, its subsidiaries (excluding those involved in AGMH's former Financial Products Business, which was comprised of its guaranteed investment contracts ("GIC") business, its medium term notes business and the equity payment agreements associated with AGMH's leveraged lease business, collectively, the "Financial Products Business") from Dexia Holdings Inc. ("Dexia Holdings"), an indirect subsidiary of Dexia SA and certain of its affiliates (together, "Dexia").The principal operating subsidiary acquired was AGM (formerly Financial Securities Assurance Inc.). The acquired companies are . . .

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