Assured Guaranty Ltd. — Q3 2014 Form 10-Q
Business and period: Bermuda-based financial guaranty insurer providing credit protection for public finance, infrastructure and structured finance obligations. This unaudited filing covers the quarter and nine months ended September 30, 2014; comparisons are with the same 2013 periods unless noted. Dollars are in millions except per-share data.
Financial performance and position
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Total revenue | $525 | $670 | $1,073 | $959 |
| Net earned premiums | $144 | $159 | $412 | $570 |
| Net investment income | $102 | $99 | $301 | $286 |
| Net income | $355 | $384 | $556 | $459 |
| Diluted EPS | $2.09 | $2.09 | $3.13 | $2.43 |
| Non-GAAP operating income | $177 | $117 | $410 | $475 |
| Operating income per share | $1.05 | $0.64 | $2.31 | $2.51 |
Q3 total expenses were $37, including negative loss and loss-adjustment expense of $44, versus expenses of $134 and loss expense of $55 in Q3 2013. Nine-month total expenses were $298 versus $306. The filing does not present a conventional operating margin measure.
- Cash flow: For nine months, operating cash flow was $347 (2013: $146), investing cash flow was negative $79 (2013: positive $570), and financing cash flow was negative $368 (2013: negative $747). Cash ended at $82, down from $184 at year-end 2013.
- Balance sheet: Total assets were $15,369 and shareholders’ equity $5,354 at September 30, versus $16,287 and $5,115 at year-end 2013. Investment portfolio fair value was $11,449, plus cash of $82.
- Debt and liquidity: Long-term debt carrying value rose to $1,303 from $816; principal outstanding was $1,597. AGUS issued $500 of 5.0% notes due 2024, receiving net proceeds of $495. AGL reported $298 of cash and short-term investments at the parent; management said liquidity was sufficient for the next 12 months. AG Re reported $784 of excess capital and surplus, subject to regulatory distribution limits.
- Capital returns: The company repurchased 18.0 million shares for $438 in the first nine months. By November 6, 2014, 20.8 million shares had been repurchased in 2014 for $499; $301 remained under the then-current authorization. Nine-month dividends were $0.33 per share.
Changes, portfolio and notable items
- Q3 GAAP net income declined to $355 from $384, primarily reflecting lower credit-derivative fair-value gains, foreign-exchange effects and lower premiums, partly offset by lower loss expense. Nine-month net income rose to $556 from $459, mainly because credit derivatives produced fair-value gains rather than losses.
- Operating income rose in Q3 but declined for the nine-month period. Management attributed the nine-month decrease chiefly to lower premiums and credit-derivative revenues as the insured portfolio ran off and had fewer accelerations, partly offset by lower losses and commutation premiums.
- Credit-derivative fair-value gains were $255 in Q3 and $147 for nine months; these Level 3 valuations rely materially on unobservable assumptions and can be volatile. Consolidated FG VIE fair-value gains were $50 in Q3 and $232 for nine months, including a $120 gain from deconsolidating seven VIEs.
- Net financial-guaranty par outstanding fell to $418.0 billion from $459.1 billion at year-end; below-investment-grade (BIG) net par fell to $19.6 billion from $22.5 billion. Net expected loss to be paid was $933, compared with $982 at year-end.
- Expected loss estimates included a $578 net benefit for mortgage representations-and-warranties recoveries, including $294 from transactions without an agreement. The company reported approximately $3.8 billion of cumulative gross receipts and losses avoided from these efforts.
- Puerto Rico exposure was $4.9 billion net par, of which $4.7 billion was rated BIG. Puerto Rico-related risks include fiscal and liquidity pressures, proposed debt-restructuring legislation and PREPA’s forbearance arrangements. Total troubled U.S. public-finance expected losses were $333, up from $264 at year-end.
- Management revised HELOC assumptions, adding defaults associated with payment increases when interest-only periods end and increasing assumed recoveries. The combined refinements increased base-case expected HELOC losses by approximately $36.
Outlook, risks and contingencies
No quantified company-wide earnings guidance is provided. Management described improving U.S. economic conditions and stronger demand for bond insurance, while noting low interest rates, weak global conditions and uncertainty about the recovery in financial-guaranty demand. It expected scheduled premium earnings to decline unless replaced by new business or reassumed business. Q3 present value of new business production was $56 versus $40; nine-month production was $114 versus $74.
- Key exposures include Puerto Rico, legacy U.S. RMBS, Detroit and refinancing-sensitive infrastructure. The company had approximately $3.0 billion of infrastructure exposure with refinancing risk; under specified assumptions, claims on its two largest such transactions could total $1.8 billion gross during 2017–2022, with recovery potentially taking 10–35 years.
- RMBS loss estimates depend on uncertain defaults, severities, housing conditions, prepayments and recoveries. Management’s projections assume continued improvement in housing and mortgage markets; actual losses could differ materially.
- Credit-rating changes could affect business, premiums, collateral requirements and claims. S&P upgraded insurance subsidiaries to AA with stable outlook in March 2014; Moody’s affirmed ratings in July but set negative outlooks for AGC and AGUK.
- Reinsurance collectability is a risk: some counterparties are financially distressed. Certain cedants could recapture assumed business following specified rating or other triggers; disclosed potential payments were approximately $288 for AG Re and $50 for AGC if all applicable rights were exercised.
- Other contingencies include RMBS recovery litigation, the Lehman-related disputes and legacy financial-products matters. Management said litigation outcomes against the company were not expected to materially adversely affect financial position or liquidity, but could materially affect results in a particular period. A California matter was reported as subject to a settlement agreement, pending court process.
- Further rating downgrades could trigger additional claims or liquidity demands under swap, variable-rate bond, GIC and leveraged-lease arrangements. AGM’s potential liquidity claims under strip policies were approximately $1.2 billion gross if all relevant leases terminated and obligors failed to pay; no such lease-default claim had occurred as of the filing.
Investor verification priorities
- Separate recurring underwriting performance from volatile Level 3 credit-derivative and FG VIE fair-value gains; review management’s non-GAAP operating-income reconciliation.
- Test the assumptions behind the $933 expected-loss estimate and $578 R&W benefit, especially recoveries not covered by agreements.
- Monitor Puerto Rico developments and the company’s $4.9 billion net exposure, including PREPA and PRHTA outcomes.
- Review liquidity and capital at the parent and regulated-insurer levels, dividend constraints, the new debt proceeds and the pace of share repurchases.
- Track rating-agency actions, reinsurance recoverability, refinancing-sensitive infrastructure claims and material litigation developments.