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AGO > SEC Filings for AGO > Form 10-K on 29-Feb-2012All Recent SEC Filings

Show all filings for ASSURED GUARANTY LTD

Form 10-K for ASSURED GUARANTY LTD


29-Feb-2012

Annual Report


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

Introduction

AGL provides, through its operating subsidiaries, credit protection products to the United States ("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 offer insurance that protect holders of debt instruments and other monetary obligations from defaults in scheduled payments, including scheduled interest and principal payments. Financial guaranty contracts provide an unconditional and irrevocable guaranty that protects the holder of a financial obligation against non-payment of principal and interest when due.

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 generally issued by special purpose entities. The Company currently does not underwrite U.S. RMBS.

Debt obligations guaranteed by the Company's insurance subsidiaries are generally awarded ratings that are the same rating as the financial strength rating of the Assured Guaranty subsidiary that has guaranteed that obligation. Investors in products insured by AGM or AGC frequently rely on rating agency ratings. Therefore, low financial strength ratings or uncertainty over AGM's or AGC's abilities to maintain their financial strength ratings would have a negative impact on the demand for their insurance product.

A downgrade by Moody's or S&P of the financial strength ratings of the Company's insurance subsidiaries may have a negative impact on the Company's liquidity. A downgrade may trigger (1) increased claims on some of the Company's insurance policies, in certain cases, on a more accelerated basis than when the original transaction closed; or (2) termination payments or collateral posting under CDS contracts. A downgrade in the financial strength ratings may also enable beneficiaries of the Company's policies to cancel the credit protection offered by the Company and cease paying premium. A downgrade may also enable primary insurance companies that had ceded business to the Company to recapture a significant portion of its in-force financial guaranty reinsurance business.

Executive Summary

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

This executive summary of management's discussion and analysis highlights selected information and may not contain all of the information that is important to readers of this Form 10-K. 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, this Form 10-K should be read in its entirety.


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Economic Environment

The Company continued to be the most active provider of financial guaranty insurance in 2011 as a result of its financial strength and its ability to maintain its financial strength ratings in the double-A ratings category throughout the financial crisis. All of the Company's pre-2007 financial guaranty competitors, except AGM, which the Company acquired in 2009, have had their financial strength ratings downgraded by rating agencies to below investment grade levels or are no longer rated, rendering them unable to underwrite new business. However, business conditions have been difficult for the entire financial guaranty insurance industry since mid-2007 and the Company has faced challenges in maintaining its market penetration that continue today.

While the overall economic environment in the U.S. at the end of 2011 was stronger than in 2010, housing prices have not stabilized, unemployment rates have declined but remain relatively high 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 poor. 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 securitizations of 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. In addition, many states and towns have significant unfunded pension and retiree health care liabilities that create additional budgetary stress. Although total state tax collections as well as sales tax and personal income tax collections grew in 2011, overall tax collections are still weak compared with recent historical standards. In 2011, new issuance volume in the U.S. and international public finance sectors did not return to historical levels, and the market for financial guaranty insurance was hampered by ratings uncertainty and municipal rating recalibrations. The primary contributing factors to the trend of low issuance volume have been: municipal issuers took advantage of the expiring Build America Bonds program in 2010 as opposed to using financial guaranty insurance, a reduction in capital spending due to municipal budget constraints and fiscal austerity, resulting in less need for increased debt, and a reluctance to increase taxes to service principal and interest costs under new debt.

In the international arena, troubled Eurozone countries are a source of stress in global equity and debt markets as the EU determines how to support financially weaker members such as Greece. The Company's exposure to Greece and other troubled Eurozone countries is described in "-Results of Operations-Consolidated Results of Operations-Losses in the Insured Portfolio" and "-Insured Portfolio-Selected European Exposures."

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 2011 in both the global structured finance and international infrastructure finance markets and also limited new issuance activity in those asset classes the Company is actively trying to insure. 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, although the Company cannot assure that this will occur. Financial guaranties had been an essential component of capital market 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.

In 2011, the Company continued to be affected by a negative perception of financial guaranty insurers arising from the financial distress suffered by other companies in the industry during the financial crisis. In addition, the financial strength ratings of the Company's insurance subsidiaries were uncertain for most of the year. In January 2011, after affirming AGM and AGC's financial strength


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ratings at AA+ (Stable Outlook) in October 2010, S&P requested comments on proposed changes to its bond insurance ratings criteria, noting that if the proposed criteria were adopted, S&P could lower its financial strength ratings on existing investment grade bond insurers by one or more rating categories. In August 2011, S&P released its final criteria, which contained a new "largest obligor test" that had not been included in the January 2011 request for comment. The largest obligor test had the effect of significantly reducing Assured Guaranty's allowed single risk limits and limiting its financial strength rating level. Then, in September 2011, S&P placed the financial strength ratings of AGM and AGC on CreditWatch negative. It was not until November 2011 that AGM and AGC were assigned financial strength ratings of AA- (Stable Outlook). In addition, AGM and AGC's financial strength ratings have been rated Aa3 (Negative Outlook) by Moody's since December 2009. The negative perception of financial guaranty insurers arising from the financial distress suffered by other companies in the industry during the financial crisis and the rating uncertainty of the Company's insurance subsidiaries caused by S&P resulted in lower demand for the Company's insurance product during 2011.

The demand for the Company's insurance has also been negatively impacted by its credit spread. The spread is a reflection of the risk that investors perceive with the Company. The higher the spread, the greater the return investors will require for a security as to which the Company has issued a policy, and the higher the interest coupon the issuer of the security will be required to pay. If investors view the Company as being only marginally less risky, or perhaps even as risky, as the uninsured security, the coupon on a security insured by the Company may not be much lower, or may be the same as, an uninsured security offered by the same issuer. Accordingly, issuers may be unwilling to pay a premium for the Company to insure their securities if the insurance does not lower the costs of issuance.

Financial Performance of Assured Guaranty


                               Financial Results

                                                         Year Ended December 31,
                                                    2011            2010         Change
                                                    (dollars in millions, except per
                                                             share amounts)
Selected income statement data
Net earned premiums                               $    920.1     $    1,186.7   $ (266.6 )
Net investment income                                  391.0            354.7       36.3
Realized gains and other settlements on credit
derivatives                                              6.0            153.5     (147.5 )
Net unrealized gains (losses) on credit
derivatives                                            553.7           (155.1 )    708.8
Net change in fair value of financial guaranty
variable interest entities                            (132.0 )         (273.6 )    141.6
Loss and LAE                                          (461.9 )         (412.2 )    (49.7 )
Other operating expenses                              (193.0 )         (211.5 )     18.5
Net income.                                            775.6            493.7      281.9
Diluted earnings per share                        $     4.18     $       2.61   $   1.57
Selected non-GAAP measures(1)
Operating income                                  $    604.4     $      664.1   $  (59.7 )
Operating income per share                              3.26             3.51      (0.25 )
Present value of new business production
("PVP")                                                242.7            362.7     (120.0 )


--------------------------------------------------------------------------------
    (1)


Please refer to "-Non-GAAP Financial Measures."

Business Overview

The Company reported net income of $775.6 million in 2011, an increase of 57.1% over 2010, primarily as a result of lower fair value losses on consolidated financial guaranty variable interest entities ("FG VIEs"), and the widening of AGC credit spreads, which have the effect of increasing unrealized gains on credit derivatives. Credit spreads of underlying CDS obligations and consolidated FG VIEs, and the Company's own credit spreads, have had a significant effect on reported net income. Non-GAAP operating income was $604.4 million in 2011 compared with $664.1 million in 2010.


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The decrease in net earned premiums was consistent with the expected amortization of deferred premium revenue and was offset in part by an increase in refundings and accelerations. Net investment income increased due to a shift from cash and short term assets to the fixed-income portfolio and additional earnings on higher invested asset balances. Realized gains and other settlements on credit derivatives decreased due to expected decreases in revenues received as the book of business amortizes and also due to an increase in claim payments on credit derivatives. Loss and LAE in 2011 benefited significantly from increased estimates of recoveries for breaches of R&W which largely offset increases in projected losses on the U.S. RMBS portfolio. Reported loss and LAE includes the recognition of losses due to amortization of the deferred premium revenue component of the stand-ready obligation. Net economic loss development measures changes in the ultimate expected losses of the Company and was $123.8 million in 2011 driven primarily by increases in projected losses on Greek exposures and other structure finance obligations.

In 2011, the Company focused on three principal strategies: loss mitigation, including the pursuit of recoveries for R&W breaches and of servicing improvements; strengthening its capital position to address S&P's new bond insurance rating criteria; and new business development.

Loss Mitigation

Net expected loss to be paid for both financial guaranty insurance and credit derivatives increased $123.8 million in 2011. The Company continued its risk remediation strategies which lowered losses and also created additional rating agency capital. The following are examples of the strategies employed by the Company.

The Bank of America Agreement (See "-Results of Operations-Consolidated Results of Operations-Losses in Insured Portfolio-U.S. RMBS Loss Mitigation") and progress made on negotiations with other significant U.S RMBS R&W providers reduced expected losses by $1,038.5 million in 2011. For transactions with other sponsors of U.S. RMBS, against which the Company is pursuing R&W claims, the Company has continued to review additional loan files and has found breach rates consistent with those in the Bank of America transactions and has therefore increased the benefit for R&W to reflect the probability that actual recovery rates may be higher than originally expected. Excluding the benefit for R&W, expected loss to be paid on U.S. RMBS increased by $1,039.2 million, which reflects a slower recovery in the housing market than previously anticipated.

The Company is continuing to purchase attractively priced BIG obligations it had already insured in order to mitigate losses, which resulted in a reduction to net expected loss to be paid of $429.1 million as of December 31, 2011. As of December 31, 2011, the carrying value of assets purchased for loss mitigation purposes was $452.7 million, with a par of $1,560.4 million.

The Company has established a group to mitigate RMBS losses by influencing mortgage servicing, including, if possible, causing the transfer of servicing or establishing special servicing. As a result of the Company's efforts, at December 31, 2011 the servicing of approximately $934 million of mortgage loans had been transferred to a new servicer and another $2.3 billion of mortgage loans were being special serviced. ("Special servicing" is an industry term referencing more intense servicing applied to delinquent loans aimed at mitigating losses.) The Company also agreed to terminate its exposure to certain structured finance risks, and it reassumed risks that it had ceded to certain lower rated reinsurers.

Improve Capital Position

Since S&P's January 2011 announcement that it planned to change its bond insurer rating criteria, the Company has been pursuing strategies to improve its rating agency capital position. In addition to its focus on loss mitigation and new business development, the Company increased capital under rating agency capital models by agreeing to terminate CDS with net par of $11.5 billion, resulting in $24.7 million in accelerated revenues. In addition, several CMBS CDS contracts, which carried high rating agency capital charges, were terminated for a payment of $22.5 million in 2011.

In addition, in January 2012, AGC and AGM entered into an aggregate excess of loss reinsurance facility that covers certain U.S. public finance credits insured or reinsured by AGC or AGM as of


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September 30, 2011. At AGC's and AGM's option, the facility will cover losses occurring from January 1, 2012 through December 31, 2019 or from January 1, 2013 through December 31, 2020. The contract terminates, unless AGC and AGM choose to extend it, on January 1, 2014. The facility attaches when AGC's or AGM's net losses exceed in the aggregate $2 billion and covers a portion of the next $600 million of losses, with the reinsurers assuming pro rata in the aggregate $435 million of the $600 million of losses and AGC and AGM jointly retaining the remaining $165 million of losses. The reinsurers are required to be rated at least AA- (Stable outlook) through December 31, 2014 or to post collateral sufficient to provide AGM and AGC with the same reinsurance credit as reinsurers rated AA-. This facility provides additional rating agency capital credit.

New Business Development

Management believes that 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, particularly with regard to the U.S. public finance market. Few individual or even institutional investors have the analytic resources to cover the tens of thousands of municipal credits in the market. Through its financial guaranty, the Company undertakes the tasks of credit selection, analysis, negotiation of terms, surveillance 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.

Reduced issuances in the U.S. public finance market and ratings uncertainty caused by S&P's bond insurer rating criteria hampered new business development throughout most of 2011. The Company's U.S. public finance market penetration in 2011 was 12.1%, based on the number of new issue transactions, and 5.3%, based on the amount of new issue par sold. In its principal target market, issuances of single-A underlying credit quality, the Company guaranteed 37.8% of the transactions sold and 15.8% of the related par. Among issues with par amounts of $25 million or less, the Company guaranteed 14.7% of the aggregate par sold across all rating categories.

In addition, the Company sought other means to increase value through commutations of previously ceded books of business. In 2011, the Company cancelled an assumed reinsurance contract for a gain of $8.1 million and cancelled ceded reinsurance contracts for a gain of $24.1 million.

As a continuation of its strategy to create value through new business and commutation, on January 24, 2012, the Company announced a three-part agreement with Radian under which it reassumed $12.9 billion of par it had previously ceded to Radian, reinsured approximately $1.8 billion of Radian public finance par and agreed to acquire MIAC, which is licensed to provide financial guaranty insurance and reinsurance in 38 U.S. jurisdictions including the District of Columbia. The purchase of MIAC is subject to regulatory approval and is expected to close in the first half of 2012.


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                            New Business Production

                                                     Year Ended December 31,
                                                    2011       2010       2009
                                                          (in millions)
       Present Value of New Business Production
       Public Finance-U.S.
       Primary Markets                            $  148.0   $  285.6   $  557.1
       Secondary Markets                              25.0       42.5       57.1
       Public Finance-non-U.S.
       Primary Markets                                 2.7          -        1.6
       Secondary Markets                                 -        0.7        0.2
       Structured Finance-U.S.                        59.8       30.2       23.2
       Structured Finance-non-U.S.                     7.2        3.7        1.0

       Total PVP                                  $  242.7   $  362.7   $  640.2

       Gross Par Written                          $ 16,892   $ 30,759   $ 49,921

PVP represents the present value of estimated future earnings primarily on new financial guaranty contracts written in the period, before consideration of cessions to reinsurers. See "-Non-GAAP Measures-PVP or Present Value of New Business Production."

The following table presents additional detail with respect to the Company's penetration into the U.S. public finance market.

                            Municipal Market Data(1)

                                                Year Ended December 31,
                                 2011                     2010                     2009
                                   Number of                Number of                Number of
                          Par        issues        Par        issues        Par        issues
                                     (dollars in billions, except number of issues)
New municipal bonds
issued                  $ 285.2         10,176   $ 430.8         13,594   $ 406.8         11,412
Insured by all
financial guarantors       15.2          1,228      26.8          1,697      35.4          2,012
Insured by AGC and
AGM                        15.2          1,228      26.8          1,697      34.8          2,005
Issued under Build
America Bonds program         -              -     117.3          1,567      64.2            784
Insured under Build
America Bonds program
by AGC and AGM                -              -       4.7            153       1.7             87


--------------------------------------------------------------------------------
    (1)


Based on the date the transactions are sold.

In the fourth quarter 2011, Assured Guaranty took advantage of emerging opportunities in the global infrastructure and structured finance markets. In the international infrastructure sector, the Company closed its first significant transaction in over two years, when it replaced another guarantor on a UK Private Finance Initiative bond issue that had been used to finance the construction and operation of the Worcestershire Royal Hospital. Structured finance PVP also increased in 2011, primarily due to a fourth quarter transaction in which the Company provided regulatory capital relief for a life insurance company.

Results of Operations

Estimates and Assumptions

The Company's consolidated financial statements include amounts that are determined using estimates and assumptions. The actual amounts realized could ultimately be materially different from the amounts currently provided for in the Company's consolidated financial statements. Management believes the most significant items requiring inherently subjective and complex estimates are expected losses, including assumptions for breaches of R&W, fair value estimates, other-than-temporary impairment ("OTTI"), deferred income taxes, and premium revenue recognition.


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An understanding of the Company's accounting policies for these items is of critical importance to understanding its consolidated financial statements. See "Item 8. "Financial Statements and Supplementary Data" of this Form 10-K for a discussion of significant accounting policies and fair value methodologies. The following discussion of the results of operations includes information regarding the estimates and assumptions used for these items and should be read in conjunction with the notes to the Company's consolidated financial statements.

Comparability of Periods Presented

Consolidation of FG VIE

The adoption of a new consolidation model for VIEs on January 1, 2010 affects comparability for 2011 and 2010 when compared to 2009. On January 1, 2010, 21 FG VIEs were consolidated at fair value. As of December 31, 2011 and 2010, the Company had consolidated 33 and 29 FG VIEs, respectively. In 2011 and 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 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.

Adoption of Revised OTTI Standard

. . .

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