Assured Guaranty Ltd. — Q3 2011 Form 10-Q
Business context and reporting period. Bermuda-based financial guarantor providing credit protection in public finance, infrastructure and structured finance. This unaudited report covers the three and nine months ended September 30, 2011; comparative 2010 results were restated. The company had shifted toward public finance, was selectively underwriting structured finance, had not insured new U.S. RMBS since 2008, and had stopped selling new CDS protection in 2009.
Key financial metrics
| Metric | Q3 2011 | Q3 2010, restated | Nine months 2011 | Nine months 2010, restated |
|---|---|---|---|---|
| Total revenue | $1,345.2 million | $347.5 million | $1,740.4 million | $1,436.2 million |
| Net earned premiums | $211.1 million | $288.8 million | $695.1 million | $900.4 million |
| Net investment income | $93.5 million | $85.6 million | $290.7 million | $260.8 million |
| Loss and LAE expense | $215.0 million | $110.8 million | $313.3 million | $307.4 million |
| Net income | $761.2 million | $164.6 million | $859.2 million | $677.2 million |
| Diluted EPS | $4.13 | $0.88 | $4.61 | $3.58 |
| Non-GAAP operating income | $38.3 million | $222.6 million | $430.9 million | $511.4 million |
Drivers and quality of earnings. Q3 GAAP net income included $1,155.5 million of unrealized credit-derivative gains, principally reflecting wider credit spreads on Assured Guaranty entities; those gains are market-sensitive and management said such non-economic fair-value changes are expected to reverse over time, absent claims or other events. Nine-month unrealized credit-derivative gains were $829.8 million. By contrast, non-GAAP operating income declined year over year, reflecting lower earned premiums, higher loss expense and a prior-year tax benefit. Q3 loss expense also reflected lower discount rates, partly offset by higher estimated representations-and-warranties (R&W) recoveries.
Premiums fell 27% in Q3 and 23% year to date, mainly as the structured-finance book ran off. Management said scheduled premium earnings were in line with expectations and noted that premium income is expected to decline absent replacement business. Investment income increased with a shift toward longer-duration assets and investment of Bank of America settlement proceeds. The nine-month effective tax rate was 27.3%; comparisons are affected by a $55.8 million tax benefit recorded in Q3 2010.
Balance sheet, cash flow and portfolio
- At September 30, 2011, total assets were $18.405 billion, total liabilities $13.638 billion and shareholders’ equity $4.767 billion, compared with $19.842 billion, $16.108 billion and $3.733 billion, respectively, at restated year-end 2010.
- Cash was $173.3 million; short-term investments were $873.3 million. The investment portfolio totaled $11.262 billion, including $10.091 billion of fixed maturities. Long-term debt carrying value was $1.042 billion; principal outstanding was $1.355 billion.
- Nine-month operating cash flow was $601.0 million, versus cash used of $104.3 million in 2010; investing cash flow was $357.9 million and financing cash flow was $(897.7) million. Operating cash flow included FG VIE activity and proceeds associated with the Bank of America agreement. Cash at period-end was $173.3 million.
- Net insured par outstanding was $571.7 billion, down from $617.1 billion at year-end 2010. Below-investment-grade (BIG) net par was $27.2 billion, or 4.8% of total net par, versus $26.8 billion, or 4.3%, at year-end. U.S. RMBS represented $22.5 billion of net par; $15.3 billion of that exposure was BIG.
- Management’s aggregate net expected loss to be paid across the insured portfolio was $1.319 billion at September 30, 2011, versus $1.063 billion at year-end 2010. This estimate is assumption-sensitive; the filing highlights mortgage defaults, severity, timing, discount rates and recoveries as important variables.
Material changes, outlook and risks
- Restatement and controls: The company restated 2010 statements for errors eliminating intercompany activity between insurance subsidiaries and consolidated FG VIEs, plus other immaterial errors. Restatement reduced December 31, 2010 equity by $65.3 million and reduced Q3 and nine-month 2010 net income by $16.3 million and $29.2 million, respectively. Six-month 2011 net income was also restated upward by $30.3 million. Management identified a material weakness in financial reporting controls over FG VIE intercompany eliminations; disclosure controls were ineffective at September 30. Remediation steps were introduced, but had not operated long enough for management to conclude the weakness was remediated.
- R&W recovery: Under the Bank of America agreement covering 29 RMBS transactions, the company received $985.4 million for second-lien transactions during the first nine months and expected another $114.6 million by March 2012. For covered first-lien transactions, Bank of America agreed to reimburse 80% of claims up to specified collateral-loss limits; the company estimated $615.1 million of related future recoveries at quarter-end. Recovery estimates and other litigation recoveries remain uncertain.
- Ratings and capital: S&P placed the insurer ratings on CreditWatch Negative in September, citing portfolio concentration and new criteria. Management was considering capital-creation or reinsurance transactions but gave no assurance they could be completed on acceptable terms. A downgrade could weaken new business, accelerate claims or GIC withdrawals, trigger CDS collateral or termination payments, and prompt reinsurance recapture. Management expected sufficient liquidity for the next 12 months. The $300 million revolving facility expired November 6, 2011 and was not renewed; the company said it did not then need a replacement.
- Business outlook: No formal earnings guidance is provided. New-business present value (PVP) was $50.8 million in Q3 versus $88.9 million, and $155.2 million year to date versus $257.6 million. U.S. municipal issuance was $188.0 billion for the first nine months, down 37% year over year. Management cited ratings uncertainty and lower municipal issuance as constraints, while noting improved quarterly penetration in U.S. public finance.
- Other exposures and contingencies: Jefferson County, Alabama filed for Chapter 9 bankruptcy on November 9, 2011; the company had $731.8 million net exposure and estimated $18.0 million expected loss on sewer warrants at quarter-end. The filing also discusses Greek sovereign debt, stressed U.S. RMBS, TruPS and life-insurance securitizations, litigation, and reliance on Dexia support for legacy GIC-related obligations. A court ruling in an RMBS reimbursement dispute could leave up to approximately $144 million of claims unreimbursed over the transaction’s life; the company intended to appeal. Management said market risk had not changed materially from year-end 2010.
Investor verification priorities
- Reconcile GAAP earnings to operating income and isolate the impact of credit-derivative fair-value gains, especially the effect of Assured Guaranty’s own credit spreads.
- Review the restatement disclosures, material weakness, remediation testing and any subsequent control or reporting developments.
- Test the assumptions behind expected losses and R&W recoveries, including the Bank of America agreement’s collateral, reimbursement limits and collection timing.
- Confirm S&P and Moody’s rating actions and whether proposed capital or reinsurance measures were completed; assess resulting collateral, liquidity, recapture and claim risks.
- Track cash and holding-company liquidity after expiration of the revolving facility, along with restricted insurer dividends and Dexia’s ability to meet legacy support obligations.
- Monitor Jefferson County bankruptcy developments, the RMBS reimbursement appeal and other material litigation or recoveries.