As filed with the Securities and Exchange Commission on April 8, 2004

Registration Statement No. 333-112828

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

AMENDMENT NO. 2
TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933

AMERICAN CAPITAL ACCESS HOLDINGS LIMITED

(Exact Name of Registrant as Specified in its Charter)


Bermuda	6351	Not Applicable
(State or other jurisdiction of incorporation or organization)	(Primary Standard Industrial Classification Code Number)	(I.R.S. Employer Identification No.)

44 Church Street
Hamilton HM 12, Bermuda
(441) 295-3688

(Address, including zip code, and telephone number, including area code, of Registrant's principal executive office)

Stephen D. Cooke, Esq.
ACA Financial Guaranty Corporation
140 Broadway
New York, New York 10005
(212) 375-2000

(Name, address, including zip code, and telephone number, including area code, of agent for service)

Copies to:


Michael J. Silver, Esq.				Ethan T. James, Esq.
Christine M. Pallares, Esq.				Davis Polk & Wardwell
Hogan & Hartson L.L.P.				450 Lexington Avenue
875 Third Avenue				New York, New York 10017
New York, New York 10022				(212) 450-4000
(212) 918-3000

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act of 1933, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.

If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following
box.

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and we are not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

Subject to completion, dated April 8, 2004

Prospectus

Common shares

This is an initial public offering of common shares by American Capital Access Holdings Limited. ACA Holdings is selling common shares. The estimated initial public offering price is between $ and $ per share.

We intend to apply to list our common shares on the New York Stock Exchange under the symbol "ACA."

Per Share

Total

Initial public offering price

Underwriting discounts and commissions

Proceeds to ACA Holdings, before expenses

ACA Holdings has granted the underwriters an option for a period of 30 days to purchase up to additional common shares on the same terms as set forth above to cover over-allotments, if any.

Investing in our common shares involves a high degree of risk. See "Risk Factors" beginning on page 9.

None of the Securities and Exchange Commission, any state securities commission nor any other regulatory body has approved or disapproved these securities or passed upon the accuracy of this prospectus. Any representation to the contrary is a criminal offense.

JPMorgan

, 2004

TABLE OF CONTENTS


	Page
Prospectus Summary		1
Risk Factors		9
Forward-Looking Statements and Projections		27
Use of Proceeds		28
Dividend Policy		28
Capitalization		29
Dilution		30
Selected Consolidated Financial and Other Data		31
Management's Discussion and Analysis of Financial Condition and Results of Operations		33
Industry Overview		59
Business		65
Management		94
Executive Compensation		99
Principal Shareholders		108
Certain Relationships and Related Transactions		112
Description of Our Share Capital		114
Shares Eligible for Future Sales		122
Material U.S. Federal Income Tax and Bermuda Tax Considerations		124
Underwriting		138
Validity of Securities		140
Experts		140
Where You Can Find Additional Information		140
Index to Consolidated Financial Statements		F-1
Certain Ratings Information	Appendix A

In this prospectus, "we," "us" and "our" refer to American Capital Access Holdings Limited, or ACA Holdings, and its subsidiaries and not to the underwriters.

PROSPECTUS SUMMARY

You should read the entire prospectus carefully, especially the matters discussed in "Risk Factors." All share amounts and related terms contained in this prospectus have been adjusted to reflect a 5.63 for 1 share split which we will effect prior to the consummation of this offering and the conversion of all outstanding convertible preference shares and senior convertible preferred shares which will automatically convert into common shares immediately prior to the consummation of this offering.

OUR BUSINESS

Overview

ACA Holdings conducts business through its subsidiaries in the following areas:


•	Municipal Bond Insurance: We provide insurance on municipal bonds that guarantees the timely payment of interest and principal. This is known as financial guaranty insurance and providers of this type of insurance are referred to as financial guarantors or financial guaranty insurers.

•

Financial Services: We participate in the market for structured finance products called collateralized debt obligations, or more commonly, CDOs. We originate and structure CDOs as well as manage the financial assets that comprise the CDOs. Originating and structuring CDOs generally involves the acquisition of corporate obligations or asset-backed securities and the packaging of these obligations and securities within an investment entity. The investment entity issues debt obligations to institutional investors, and these obligations are repaid with the cash flows from the underlying obligations and securities.


•	Customized Solutions: In addition to our financial guaranty insurance, we also provide other types of specialized insurance products for the financial and insurance markets.

Our personnel have expertise in analyzing credit, assessing risk in financial instruments and structuring transactions to suit the specific needs of our clients. We use this expertise in all of our business lines.

Our financial guaranty insurance business has an "A" ("strong", the sixth highest of twenty rating levels) financial strength rating from Standard & Poor's Rating Group, a division of The McGraw-Hill Companies, or S&P, and an "A" ("strong", the sixth highest of nineteen rating levels) financial strength rating from Fitch Ratings Inc., or Fitch. A "financial strength" rating relates to our ability to pay under our insurance policies. We use our financial guaranty insurance to enhance the credit rating of lower-rated and non-rated municipal bonds to an effective "A" rating. This allows municipal bond issuers to borrow at a lower cost and increases the marketability of their bonds.

We receive premiums from municipal bond issuers in exchange for providing insurance against payment defaults. Nearly half of all municipal bonds outstanding carry some form of financial guaranty insurance, and the vast majority of insured municipal bonds are insured by financial guarantors whose credit ratings are "AAA" (which is the highest financial strength rating assigned by the rating agencies). Due to both rating agency and internally imposed constraints, these "AAA" financial guarantors generally do not insure non-investment grade or non-rated municipal bonds. By contrast, our "A" financial strength rating combined with our expertise in credit analysis allows us to guarantee the bonds of issuers in this underserved segment of the market. As of December 31, 2003, we had insured obligations consisting of $8.6 billion net par outstanding, which is equal to the outstanding principal amount of obligations net of reinsurance, $5.6 billion of which represents our insured municipal bond portfolio. From our inception in 1997 through December 31, 2003, our paid losses and expenses relating to the settlement of losses, net of recoveries, have been less than 1% of the total net insurance premiums we received during this period.

Within our financial services business, we receive fees for originating and structuring CDOs and managing the financial assets that comprise CDOs:


•	We originate CDOs by collaborating with financial institutions, such as investment banks, to create new CDOs and assist in the selection and acquisition of the financial assets that will comprise the CDO.

•

We structure CDOs by seeking to ensure that the cash flows from the underlying financial assets of the CDO meet the debt obligations of the CDO. These debt obligations are divided into layers, or tranches, with different priorities of claims on the cash flows from the underlying financial assets of the CDO. These priorities reflect a tranche's exposure to risk from potential losses on the underlying financial assets of the CDO.

•

We manage CDOs by actively monitoring the credit worthiness of the issuers of the underlying financial assets and trading the underlying financial assets of the CDO. We believe that our ability to manage these underlying financial assets of the CDO allows us to mitigate losses as they develop, and to lower the risk of defaults by selling the financial assets of the CDO that develop an increased risk of default.

In addition to these fee-based services, we assume the risk up to the principal amount of the most junior, or equity, tranche of the CDO. This equity tranche, which generally represents a small portion of the total assets of the CDO, is also known as the "first-loss" layer because it absorbs any initial losses on the financial assets of the CDO. By assuming the risk associated with the equity layer, we become entitled to the difference, often referred to as excess spread, between the payments the CDO receives from the underlying financial assets of the CDO and the payments that the CDO makes to holders of its debt obligations. We believe that this approach increases and diversifies our economic return by complementing our fee-based revenue with risk-based revenue. We completed our first CDO in January 2002 and have completed a total of seven transactions to date with $6.0 billion of CDO assets under management.

Through our customized solutions business, we use our expertise in credit analysis and quantitative risk assessment to offer insurance and structured finance products to our clients. Our customized insurance products assist financial institutions in meeting their regulatory, accounting or capital requirements. Products that we currently provide include:


•	Financial guaranty insurance of the most senior liability, commonly referred to as the "super-senior" tranche, of CDOs structured by third parties.


•	Reinsurance of discrete amounts that allows us to selectively participate in the property catastrophe insurance market.

We expect that the types of customized solutions we offer will vary as market opportunities arise. As of December 31, 2003, we had $2.8 billion of total insured exposure related to our customized solutions business.

For the year ended December 31, 2003, we had total revenues of $108.0 million and net income of $17.2 million. Our shareholders' equity was $194.3 million at December 31, 2003.

The Municipal Finance Market

The U.S. municipal finance market includes debt obligations issued by states, political subdivisions (cities, counties and towns), utility districts, airports, higher educational institutions, hospitals, transportation, housing authorities and other similar authorities and agencies. These obligations are generally supported by the issuer's taxing authority or ability to collect fees or assessments for projects or public services. Our municipal bond insurance business involves guaranteeing obligations in virtually all of these categories, but we specifically target low- and non-investment grade or non-rated issuers. In 2003, there were over 15,000 new issues in the U.S. municipal finance market with a par amount of approximately $384 billion. Of these issues, 4,300, with a par amount of approximately $36

billion, were low and non-investment grade or non-rated. For the year ended December 31, 2003, we insured 66 of these new issues with a par amount of $981 million.

The Collateralized Debt Obligation (CDO) Market

The market for CDOs developed in the late 1980s and has experienced considerable growth over the last seven years. U.S. CDO issuance in 2003 was approximately $150 billion in total principal amount compared to approximately $36 billion in 1997. The CDOs we completed in 2003 had a total principal amount of $3.6 billion.

Competitive Strengths

We believe we possess the following competitive strengths:


•	Focus on credit analysis and risk management. We emphasize the importance of rigorous credit analysis throughout our insurance and financial services businesses. We have established systems of risk management and risk surveillance that we apply to all of our product offerings.

•

Use of "A" financial strength rating to provide financial guaranty insurance to underserved segments of the municipal finance market. We are currently the only financial guarantor that has an "A" financial strength rating. All other financial guarantors that serve the municipal finance market are rated "AAA" or "AA." The insurers with "AAA" or "AA" ratings generally are not able or choose not to guarantee the bonds of non-investment grade and non-rated issuers due to both rating agency and internally imposed constraints. By contrast, our "A" financial strength rating combined with our expertise in credit analysis allows us to provide financial guaranty insurance to these underserved issuers. We carefully analyze each issuer we insure to mitigate the increased risk associated with the low or non-existent underlying rating of their bonds.


•	Unique approach to structured finance. Through our participation in the CDO market, we receive both fee-based and risk-based revenues while limiting our risk of economic loss to the first loss layer of a CDO. This provides us with higher returns than would be available if we acted solely as a traditional financial guarantor by insuring debt obligations of the CDO, while also limiting our risk.


•	Management team with significant industry and operating experience. Our management team is led by our Chief Executive Officer, who has worked in the financial guaranty insurance and structured finance markets for 22 years. Our senior management team collectively averages over 17 years in the financial services industry.

Business Strategy

Our goal is to generate recurring revenues that will provide returns on our capital, adjusted for risk, that are superior to those of our competitors by adhering to the following strategies:

•

Capitalize on the flexibility of our "A" financial strength rating. In the municipal finance market, our "A" financial strength rating allows us to provide financial guaranty insurance to issuers that are historically underserved by "AAA" rated financial guarantors. Because of the number of active market participants, premium levels for "AAA" or "AA" financial guaranty insurance are quite competitive. By contrast, we can charge premiums that reflect the greater risk we assume. We intend to continue to capitalize on the advantages that we believe our "A" financial strength rating affords us.

•

Pursue growth opportunities in underpenetrated segments of the municipal finance market. We target the lower- or non-rated segment of the municipal finance market, which we believe has strong growth potential. As issuers in this segment seek financial guaranty insurance, we believe our established reputation as a long-time provider to this market segment will give us an advantage over other potential competitors.


•	Continue the origination of our CDOs. We intend to continue to originate, structure and manage the assets of new CDOs. We believe that we can build on our track record of managing CDOs, which should enhance market reception to our new CDOs with new asset classes.

•

Seek diversified revenues from multiple sources. We intend to maintain the diversity of our revenues, including fees, premiums and investment income. In addition, we will continue to generate revenues from multiple sources, including municipal finance, structured finance and other insurance products. We believe that this approach will limit our exposure to negative cycles in one or more of these markets.


•	Offer new insurance products and services to our clients. We intend to use our expertise in credit analysis and quantitative risk management to create and offer new products for the insurance and structured finance markets.

Risks

Any analysis of our competitive strengths and our business strategy must be balanced by an analysis of some of the risks we face and other countervailing factors that could adversely affect our future. These include:

•

We may not accurately analyze the credit and other risks we assume. A fundamental part of our business involves accurate and timely analysis of credit risk and other risks we assume. We could suffer extensive losses if we do not accurately analyze the risk of default or credit quality deterioration in the obligations we insure or in the financial assets in our CDOs. These losses could jeopardize our financial position.

•

We may not be able to maintain our "A" financial strength rating. The rating agencies that have assigned us "A" financial strength ratings could revise or withdraw these ratings at any time. If they did so, we would be unable to continue our current business of insuring municipal obligations and our CDO and customized solutions businesses would be materially hurt. We are required to have $300 million in capital (which may include first loss or excess of loss reinsurance, bank letters of credit or other facilities) by December 31, 2004 in order to maintain our S&P rating, and Fitch has stated that a rating action could be forthcoming if we do not raise the additional capital contemplated by this offering. While we expect that the consummation of this offering will address these concerns, losses in excess of our expectations could diminish our capital.


•	We may need more capital for growth. Because of both rating agency and insurance regulatory factors, we may need significant amounts of additional capital in the future to continue our growth. That additional capital may not be readily available or may be very costly to obtain.


•	Our CDO business is relatively new and may not perform as we expect. We completed our first CDO only in 2002 and have only completed seven CDO transactions in total. It will be several years before we know whether these CDOs have performed as we expect. If they do not, we may suffer losses and be unable to increase our participation in the CDO market.


•	Our insurance reserves may be inadequate. We do not use traditional actuarial methods to establish reserves for our financial guaranty insurance business, but must rely on an uncertain process of estimating future losses based on the limited available information regarding defaults. If we do not accurately establish our reserves, our losses may adversely affect our future income and capital.

Our business is inherently complex and our financial statements now, and future financial reporting will, reflect this complexity. Our recent significant growth strained our resources and, as a result, in 2003 we had to take steps to improve our systems and controls. In addition, the U.S. federal income tax treatment of our company and our shareholders is complex and involves some judgments and uncertainties that investors are urged to consider carefully. There are further discussions of all of these matters elsewhere in this prospectus, and we encourage you to read these discussions carefully.

Additional Information

We were originally incorporated in 1997 and moved our domicile to Bermuda in 2002. We are a holding company that conducts all of its operations through subsidiaries in the United States and other jurisdictions, including Bermuda.

Our principal executive office is located at 44 Church Street, Hamilton HM 12, Bermuda and our telephone number is (441) 295-3688. We maintain a website at www.aca.com. Information on our website is not a part of this prospectus.

THE OFFERING


Common shares offered		shares


Common shares to be outstanding after this offering (1)		shares


Use of proceeds		We estimate that our net proceeds from the initial public offering of our common shares, after deducting the underwriting discounts and commissions and our estimated offering expenses, will be approximately $ million. We estimate that our net proceeds will be approximately $ million if the underwriters exercise their over-allotment option in full. We intend to use the net proceeds of this offering for general corporate purposes.


Proposed NYSE symbol		"ACA"


Dividend policy		We do not anticipate paying dividends on our common shares in the foreseeable future. We plan to retain earnings for use in the operation of our business and to fund future growth.


(1)	The number of common shares to be outstanding after this offer excludes:


•	common shares issuable upon the exercise of the underwriters' over-allotment option;


•	2,015,212 common shares issuable upon the exercise of outstanding stock options at a weighted average exercise price of $11.44 per share; and


•	common shares issuable upon the exercise of stock options to be issued upon the consummation of this offering, at an exercise price equal to the initial public offering price set forth on the cover page of this prospectus.

Summary Consolidated Financial and Other Data

The following table sets forth summary historical consolidated financial and other data as of and for the years ended December 31, 2003, 2002 and 2001. We derived our summary consolidated financial data as of and for the years ended December 31, 2003, 2002 and 2001 from our audited consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP, and audited by PricewaterhouseCoopers LLP, our independent auditors. Our historical results are not necessarily indicative of our results for any future period. You should read the data set forth below in conjunction with our consolidated financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information appearing elsewhere in this prospectus.


	For the Year Ended
	Dec. 31,		Dec. 31,			Dec. 31,
	2003		2002			2001
	(in thousands, except per share amounts)
Income Statement Data:
Gross premiums written	$	66,014	$	55,264		$	23,021
Net premiums written		62,549		47,434			5,459
Premiums earned		23,836		13,976			6,672
Net investment income		52,868		20,269			11,567
Net realized gains (losses)		3,188		4,138			6,511
Net realized and unrealized gains (losses) on derivative instruments		6,821		(8,666	)		—
Derivative income		11,972		4,975			—
Fee income		8,898		4,236			194
Other income		423		676			—
Total revenues		108,006		39,604			24,944
Loss and loss adjustment expenses		3,168		1,801			1,636
Policy acquisition costs		4,077		4,046			3,680
Other operating expenses		29,466		18,683			14,304
Interest expense		42,046		9,869			126
Depreciation and amortization		1,329		1,081			730
Reorganization costs		—		—			1,749
Total expenses		80,086		35,480			22,225
Income (loss) before income taxes		27,920		4,124			2,719
Provision (benefit) for income taxes		10,717		(444	)		110
Net income (loss)	$	17,203	$	4,568		$	2,609
Basic earnings (loss) per share	$	2.92	$	0.77		$	0.45
Diluted earnings (loss) per share		1.37		0.37			0.23
Weighted average number of common shares outstanding:
Basic		5,886		5,895			5,786
Diluted		12,559		12,268			11,136


	Dec. 31, 2003		Dec. 31, 2002		Dec. 31, 2001
	(in thousands, except share amounts)
Summary Balance Sheet Data:
Cash and investments (a)	$	3,321,690	$	808,545	$	231,672
Total assets (a)		3,468,426		916,966		299,062
Reserve for losses and loss adjustment expenses		9,547		6,555		3,405
Unearned premiums		172,337		136,222		101,208
Total debt (a)		2,964,332		541,470		825
Total liabilities		3,274,120		757,106		128,144
Total shareholders' equity		194,306		159,860		170,918
Per Share Data:
Book value per share (b)	$	16.03	$	13.23	$	14.38
Other Data (c):
Net par exposure (in millions)	$	8,563	$	6,378	$	5,563
CDO assets under management (in millions)		5,826		2,400		N/A
Present value of future cash flows (after tax) (d)		89,650		41,712		14,873
Statutory Financial Data (ACA Financial Guaranty) (e):
Contingency reserve (f)	$	31,520	$	21,162	$	13,959
Policyholders' surplus		137,783		123,635		106,802

(a)

Includes cash and investments related to our consolidated CDOs of $2,943.5 million and $511.3 million as of December 31, 2003 and December 31, 2002. Includes total assets related to our consolidated CDOs of $2,943.5 million and $511.3 million as of December 31, 2002, respectively. Includes debt related to our consolidated CDOs of $2,905.1 million and $523.5 million as of December 31, 2003 and December 31, 2002, respectively.


(b)	Book value per share is based on total shareholders' equity divided by basic common shares outstanding including the assumed conversion of convertible preference shares and senior convertible preferred shares.


(c)	This information is not derived from our audited consolidated financial statements.

(d)

Includes the present value of installment premiums and future cash flows from CDOs discounted at 6% in 2003, 8% in 2002 and 6% in 2001 net of taxes. Actual results will differ if the assumptions above prove incorrect. Management believes that this data provides more complete information regarding our potential future revenues. In particular, installment premiums are not reflected in unearned premiums but the present value of installment premiums is considered an important measure of future revenues for public financial guaranty insurance companies.


(e)	Derived from the statutory financial statements of ACA Financial Guaranty, which have been prepared in accordance with statutory accounting practices prescribed and permitted by the Maryland Insurance Administration, or SAP, which differ in material respects from U.S. GAAP.


(f)	Under statutory accounting principles, or SAP, we are required to establish contingency reserves based on a specified percentage of either written premiums or insured exposure by bond type. A contingency reserve is an additonal liability reserve established to protect the policyholder against the effects of adverse economic developments or cycles or other unforseen circumstances.

RISK FACTORS

You should carefully consider the risks described below, together with all of the other information in this prospectus, before deciding to invest in our common shares. We believe the risks and uncertainties described below are the material risks we currently face.

Risks Related to Our Business

If we do not accurately analyze credit and other risks we assume, we could suffer large losses.

If we do not accurately analyze the credits and other risks we assume in our insurance business, then we may not correctly price our insurance products and, therefore, we may suffer losses in excess of our expectations. If that happens our capital adequacy, which is a measure of our ability to meet future obligations with then currently available resources, will be hurt. Our financial guaranty insurance premium rates are based on, among other factors,


•	our analysis of the credit quality of the issuer of the insured obligation,


•	the difference between market interest rates on insured and uninsured obligations,


•	the amounts, known as capital charges, which the rating agencies and state insurance regulators assess against our capital based on the risk category assigned to an insured obligation,


•	and competition from other forms of credit enhancement.

Our premium rates on our other insurance products are based upon, among other factors, our expected risk of losses on the insured obligations. Approximately 43.3% of our municipal bond insurance portfolio currently consists of obligations that are non investment grade or non-rated. These obligations may be subject to a greater risk of default than obligations that are rated investment grade. While we have adopted limits on the amount of exposure we assume from a single particular issuer or credit source, a major loss on several insured securities could adversely affect the amount of our (resources available to pay claims). That could potentially result in a downgrade of the financial strength rating of our insurance subsidiary, ACA Financial Guaranty Corporation, which we refer to as ACA Financial Guaranty.

Our future success in originating, structuring and managing CDOs will depend on our ability accurately and timely to analyze the financial assets that comprise the CDOs. If we fail to do this our CDOs may experience defaults and that may result in our potentially losing all of our equity interests in those CDOs. Our aggregate first loss, or equity, position in our CDOs is $161.5 million. Poor performance of our CDOs may also adversely affect our ability to originate future CDOs. To date, we have experienced no downgrades of or defaults under any of the tranches of our CDOs.

Our customized solutions business also relies on our ability accurately to assess the risks associated with the transactions we undertake. These transactions are often uniquely tailored to meet the needs of our clients and as a result we have limited historical data and experience with which to establish premium rates. Losses on these customized insurance products could also adversely affect our capital adequacy.

We try to manage our portfolio of assumed risks with regard to exposures to single credits, concentration of risk, and what we refer to as correlation of risk, which involves offsetting risks. Our failure to adequately manage these risks on an aggregate basis across all of our businesses could cause us to suffer excessive losses and could affect our capital adequacy.

If ACA Financial Guaranty fails to maintain minimum capital requirements it may not be able to write new insurance or may be downgraded by the rating agencies.

Rating agencies and state insurance regulators impose on ACA Financial Guaranty minimum capital requirements, meaning requirements to maintain specified amounts of resources available to pay claims. These capital requirements have the effect of limiting the amount of insurance that ACA Financial Guaranty may write, including with respect to single risks. Capital includes a combination of

"hard" capital, which consists of paid-in capital and retained earnings, and "soft" capital, which consists of contractual arrangements such as reinsurance agreements or credit facilities. S&P's stable ratings outlook on ACA Financial Guaranty assumes that our insurance subsidiaries will satisfy S&P's current minimum hard and soft capital requirement of $300 million (of which at least $200 million must be hard capital) by December 31, 2004. Because we were formed in 1997 when lower capital requirements were in place, we were given until December 31, 2004 to comply with S&P's current minimum capital requirements, which were adopted in 2001. Upon the consummation of this offering on a pro forma basis as of December 31, 2003, our insurance subsidiaries expect to have hard capital of $ million and aggregate hard and soft capital of approximately $ million. However, the rating agencies could revise their capital requirements at any time, and losses in excess of our expectations could diminish our capital below then required rating agency levels.

In January 2001, ACA Financial Guaranty was placed on "Rating Watch Negative" by Fitch when it appeared that we might then be unable to raise the additional capital necessary to support our "A" rating. Our need to raise additional capital at that time was the result of cumulative statutory operating losses and the failure to obtain standby capital facilities that would constitute soft capital. During the period we were on "Rating Watch Negative" our business was adversely affected. We were removed from "Rating Watch Negative" after we received commitments for $45 million of equity from existing and new shareholders. In addition, Fitch stated in March 2004 that it views our current capital and liquidity levels as insufficient to support our current insured book of business and our short-term growth aspirations at our current rating level. Although we believe that the proceeds from this offering will address these concerns, should we face similar circumstances in the future, we may not be able to raise additional hard or soft capital to avoid a rating downgrade.

ACA Financial Guaranty is also subject to state regulations that set minimum statutory capital requirements for insurance companies in relation to the amount of outstanding insured obligations and limit the amount of net exposure which ACA Financial Guaranty may insure in relation to qualified statutory capital (which is the sum of policyholders' surplus and contingency reserve). Under New York insurance law, for example, a financial guaranty insurance company must maintain policyholders' surplus of at least $65 million. As of December 31, 2003, ACA Financial Guaranty's qualified statutory capital was $169.3 million and our policyholders' surplus was $137.8 million. Material reductions in the qualified statutory capital of ACA Financial Guaranty could result from losses on our insured obligations or investment losses. Our capital may also be inadequate if our insurance in force grows because we write new policies.

Failure to meet these minimum capital requirements would limit ACA Financial Guaranty's ability to write new business, both on single risks and in the aggregate, require ACA Financial Guaranty to obtain reinsurance for existing business or could result in ratings downgrades, which then could materially adversely affect our results of operations and financial condition. Reinsurance, which can help alleviate capital needs, may be difficult or costly to obtain.

If the rating agencies lower the insurance financial strength ratings that they have assigned to ACA Financial Guaranty, our ability to generate new business across all of our business lines would be seriously hurt.

Rating agencies, such as S&P and Fitch, assign financial guaranty insurance companies, such as ACA Financial Guaranty, a "financial strength" rating. Our financial strength rating is essential to our insurance and financial services businesses. As of the date of this prospectus, ACA Financial Guaranty has been assigned an "A" financial strength rating with a "stable" outlook from both S&P and Fitch. Our ratings are subject to periodic review by the rating agencies, and the rating agencies may revise or withdraw these ratings at any time at their sole discretion. These actions may be based on factors which are entirely outside of our control, such as general industry trends, or they may reflect changes in the views or the policies of the rating agencies or adverse developments in our financial condition or results of operations, or those of ACA Financial Guaranty.

to back guarantees we have issued or in certain instances could be replaced as the collateral manager in our managed CDOs. If these events occurred, it could materially hurt our financial performance and liquidity and severely strain our capital resources.

We may require additional capital in the future, which may not be available or may only be available on unfavorable terms.

We are undertaking this offering in large part to address current capital needs. Although we believe that the proceeds of this offering should be sufficient to address our current needs, our future capital requirements depend on many factors, including the growth of our insurance and financial services businesses and losses we may incur. Because we face state insurance regulatory restrictions on the ability of our insurance subsidiaries to pay dividends and to enter into transactions with us or our other subsidiaries, funds generated in our insurance operations may not be available to fund our other operations. To the extent that the funds generated from this offering and our operations are insufficient to meet our future requirements, we may need to raise additional funds through financings. If additional funds are unavailable, we may need to curtail our growth. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. Equity or debt we may issue in the future may have rights, preferences and privileges that are senior to those of the current common shares. In the case of equity financings, our shareholders could experience dilution. If we require additional capital and are not able to obtain it on favorable terms or at all, our business, operating results and financial condition could be adversely affected.

We have a limited history of originating, structuring and managing CDOs and our CDOs may not perform as we expect.

We completed our first CDO only in 2002 and have completed a total of seven through December 31, 2003. Our CDOs have terms ranging from five to thirty years, which means that it will be several years before our first CDOs terminate and their total performance is known. As a result, there is limited historical information available to help you evaluate our track record in this type of business. It is possible that the actual performance of our CDOs may not meet our expectations or that we may suffer losses in our operations from poor performance in our CDOs. Our ability to grow our CDO business will depend on the performance of our outstanding CDOs. If our CDOs perform poorly, whether due to our failure to properly structure or manage the assets in our CDOs, the investors in our CDOs could suffer reduced returns and we may not be able to originate CDOs in the future.

We provide "first loss" protection on our CDOs. We do this by either purchasing the equity tranche of our CDO or insuring the credit default swaps, or CDSs, of our CDS CDO. A credit default swap is a contract that involves the transfer of credit risk from one party to another without removal of the associated assets from the transferor's balance sheet. We currently have approximately $161.5 million of first loss exposure in our CDOs. If our CDOs fail to perform as we expect, we could suffer losses on our first loss position.

We are still in the start-up phase of our CDO business, and our CDO business currently puts a strain on our liquidity because we are unable to distribute the excess funds generated by some of our CDOs due to the provisions of the borrowings we use to finance our purchase of the equity of some of our CDOs.

Additionally, we are required to consolidate on our balance sheet, and to mark-to-market on the balance sheet, assets related to certain of our CDOs. Mark-to-market adjustments reflect changes in the value of the securities that comprise our CDOs and are influenced by changes in factors including general economic conditions and interest rate changes. Mark-to-market adjustments reflecting unrealized losses may exceed the value of our equity participation in a CDO. Although our economic exposure to losses is limited to our equity participation in the CDO and unrealized losses may not ultimately be realized, mark-to-market adjustments reflecting unrealized losses would reduce our shareholders' equity and could cause negative investor perception of us. This could impair our ability to originate future CDOs.

We finance our purchase of the equity in our CDOs by borrowing the funds and backing our borrowing with a financial guaranty insurance policy from ACA Financial Guaranty. If we were

unable to continue financing our purchase in this manner, we would be required to commit additional capital to each CDO or establish alternative sources of financing, which may limit the number of CDOs we could originate.

If the reserves we establish for our insurance business are inadequate our results of operations may be adversely affected.

Our future results of operation and financial condition are affected by our ability to establish adequate reserves for losses we may suffer on the risks we insure. Our financial guaranties insure the financial performance of the obligations guaranteed over an extended period of time, in some cases over 30 years, under policies that we cannot cancel. As a result of the small number of losses in the financial guaranty industry in general, financial guaranty insurers like ACA Financial Guaranty do not use traditional actuarial approaches to determine loss reserves. Instead, we establish an unallocated loss reserve in an amount we deem adequate to cover the expected levels of losses and loss adjustment expenses, which consist of losses plus the expense of settling claims (including legal and other fees and the portion of general expenses allocated to claim settlement costs), on our overall portfolio. Establishing loss reserves is an inherently uncertain process. The size of our unallocated loss reserve is determined by a formula, the components of which are reviewed regularly. In our non-financial guaranty insurance business, we establish loss reserves to cover our estimated liability for the payment of all losses and adjusted loss expenses incurred on the policies that we write. These estimates are based on statistical projections and our assessment of currently available information.

Setting our loss reserves involves significant reliance upon estimates with regard to the probability, magnitude and timing of a loss. The models and estimates we use to establish loss reserves may prove to be inaccurate, especially during an extended economic downturn. There can be no assurance that the reserves we establish in any year will be adequate to cover the ultimate cost of losses incurred in that year. If our loss reserves are determined to be inadequate, we will be required to increase our loss reserves by recognizing a loss, which results in a corresponding reduction in our net income and capital in the period in which the deficiency is recognized. The effect of this could be very significant to us.

Our significant recent growth and expansion into new markets placed a strain on personnel and internal controls and reporting in prior periods, and future growth could lead to further strains that could materially and adversely affect our business.

Since 2001, we have significantly increased the scope of our financial guaranty operations and entered into markets in which we previously did not conduct business, including the origination, structuring and management of our CDOs and our customized solutions business. This growth placed a strain on our management, other personnel, resources and financial reporting systems.

To implement our business strategy, we will need to evaluate continually and, where necessary, upgrade our operating and financial systems, procedures and controls.

In connection with the audit of our financial statements for the year ended December 31, 2002, our independent auditor, PricewaterhouseCoopers LLP, recommended that we, among other things, expand our accounting staff (particularly with respect to individuals experienced in structured transactions and the application of SFAS 133, which addresses accounting for derivatives) and document policies, procedures and accounting methodology, and that we implement a function independent of operations management that is responsible for reviewing the models and data used in valuation of CDS transactions. We have expanded our accounting staff and otherwise taken the actions recommended by PricewaterhouseCoopers.

In consultation with our auditors in early 2004, we determined to restate our financial statements for the year ended December 31, 2002. The restatement related in part to the recognition of forward purchase agreements associated with the warehousing phase of our CDO business as derivatives in accordance with SFAS 133. A forward purchase agreement is a legal agreement to purchase an asset at a specified price in the future. This component of the restatement reduced our reported consolidated net income before taxes for the year ended December 31, 2002 by $8.3 million and consolidated shareholders' equity by $19.7 million.

Another component of the 2002 restatement related to the deferral of certain costs related to our financial services business. Upon further review, we determined that these costs should not have been deferred. This component of the restatement reduced our reported consolidated net income before taxes for the year ended December 31, 2002 by $4.4 million and consolidated shareholders' equity by the same amount.

We intend to continue to monitor and, where necessary, take steps to improve our controls and systems, but if we are unsuccessful in doing so, our business and results of operations could be materially and adversely affected.

General economic factors and interest rate changes may adversely affect our loss experience and the demand for our products.

Our business, and the risks associated with it, tend to track general economic and market conditions. We could incur losses due to extended economic recessions, business failures, interest rate changes or volatility, changes in investor perceptions regarding the strength of financial guaranty insurers and the policies or guaranties offered by such insurers, investor concern over the credit quality of municipalities and corporations, terrorist attacks, acts of war, or combinations of such factors. The occurrence of any of these events could also materially decrease demand for our insurance products. In addition to exposure to general economic factors, our insurance policies expose us to the specific risks faced by the particular businesses, municipalities or pools of assets covered by our insurance.

Prevailing interest rate levels affect demand for financial guaranty insurance. Higher interest rates may result in declines in new bond issue and refunding volume which may reduce demand for our financial guaranty products. Lower interest rates generally are accompanied by narrower interest rate spreads between insured and uninsured obligations resulting in generally lower cost savings to issuers than during periods of wider spreads. These lower cost savings could be accompanied by a corresponding decrease in demand for financial guaranty insurance.

The performance of our CDOs and our ability to originate future CDOs may be adversely affected by volatility or deteriorating economic and market conditions, extended economic recession, interest rate volatility, deteriorating credit environment, increasing default rates or a combination of these factors. In addition, to the extent actual defaults occur in the securities and instruments that comprise our CDOs, we could suffer losses to the extent of our equity and the investors in our CDOs could suffer reduced returns. Poor performance of our CDOs may adversely effect our ability to originate future CDOs.

If ACA Financial Guaranty's investments perform poorly, our financial results and ability to conduct business could be harmed.

Our operating results are affected in part by the performance of our investment portfolio. Income from the investment portfolio of ACA Financial Guaranty is one of our primary sources of cash flow to support our insurance operations, including our ability to pay any claims. For the year ended December 31, 2003, approximately $11.6 million of our revenue, or 10.7%, was derived primarily from ACA Financial Guaranty's investment portfolio and cash and equivalents.

ACA Financial Guaranty's investments are subject to:

•

market value risk, which is the risk that ACA Financial Guaranty's invested assets will decrease in value. This decrease in value may be due to a change in the yields realized on ACA Financial Guaranty's investment portfolio and prevailing market yields for similar assets, an unfavorable change in the liquidity of the investments or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuers of the securities in ACA Financial Guaranty's investment portfolio;


•	default risk, which is the risk that some of the investments will not pay principal or interest owed to us when due; and


•	reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than expected.

ACA Financial Guaranty's investment portfolio includes mortgage-backed securities, or MBSs, and collateralized mortgage obligations, or CMOs. As of December 31, 2003, MBSs and CMOs constituted approximately 35% of ACA Financial Guaranty's invested assets. As with other fixed income investments, the fair value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to the risk that MBS and CMO issuers will be required to prepay their obligations. In periods of declining interest rates, mortgage prepayments generally increase and MBSs and CMOs are prepaid more quickly, potentially requiring us to reinvest the proceeds at less attractive interest rates.

Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Although we take measures to manage the risks of investing in a changing interest rate environment, we may not be able to mitigate interest rate sensitivity effectively. Although we have not done so in the past, we may also enter into interest rate, foreign currency and credit derivatives and other hedging transactions with respect to ACA Financial Guaranty's investment portfolio in an effort to manage risks. Structuring these derivatives and hedges so as to effectively manage these risks is an inherently uncertain process. If our calculations are incorrect, or if we do not properly structure our derivatives or hedges, we may have unexpected losses and our assets may not be adequate to meet our obligations under our policies, which could adversely affect our results of operations and financial condition.

We may need to obtain reinsurance to continue our growth, and it may not be available on favorable terms or at all, which could have an adverse impact on our ability to grow and could adversely affect our future results of operations.

In order to comply with state insurance regulatory and rating agency capital requirements and single risk limits as our business grows, we may need to obtain additional reinsurance. Reinsurance is the commitment by one insurance company, the "reinsurer," to reimburse another insurance company, the "ceding company," for losses on a specified portion of the ceding company's insurance obligations in return for a premium payment. Reinsurance allows us to grow our business by reducing the amount of our own capital we must allocate to risks we have reinsured. The market for reinsurance has recently become more concentrated. While we currently have $50 million of first loss reinsurance and $75 million of excess of loss reinsurance, we may need additional reinsurance. At the time we seek additional reinsurance, reinsurance may not be available at acceptable terms or at all. In the event that the financial strength rating of a reinsurer with whom we have a reinsurance agreement is downgraded, we will be required to allocate additional capital to the risks we have reinsured pursuant to rating agency guidelines we must follow, or find an alternative reinsurer. If we are unable to obtain sufficient reinsurance, or other similar forms of capital support, when needed, this could have an adverse impact on our ability to grow our insurance business and could adversely affect our future results of operations.

We face risks from the concentration of our liabilities and investments.

We face concentration risks in all of our businesses. While we seek diversification across our businesses, in each of our business segments and in our investment portfolio, we face risks to the extent that our aggregate exposure to losses is concentrated geographically, by industry, sector, obligor or type of credit or investment.

In particular, in our municipal financial guaranty business we face risk from the concentration of our exposure in certain states and certain industries. As of December 31, 2003, $1,102 million, or 19.7%, of our outstanding municipal financial guaranty exposure was concentrated in California-located issuers, and $2,093 million, or 37.3%, of our municipal financial guaranty exposure was concentrated in nine other jurisdictions. This concentration increases our vulnerability to economic downturns in those states. In addition, as of December 31, 2003, $1,422 million, or 25.4% of our municipal financial guaranty exposure was related to healthcare and long-term care facilities. Both the healthcare and long-term care sectors of the economy have faced rising costs and are perceived to be higher risk than other segments of the municipal finance market. These factors could undermine the assumptions we made in our credit analysis of the issuers in those sectors and cause actual losses to exceed estimated losses.

We are dependent on key executives.

Our future success depends to a significant extent on the efforts of our senior management, including Mr. Michael E. Satz, our chief executive officer, Ms. Maryam Muessel, our chief operating officer, Mr. Edward Gilpin, our chief financial officer, and Mr. William Tomljanovic, our executive vice president responsible for our customized solutions business. We currently have employment agreements with each of these individuals with terms that expire in 2007, but employment agreements do not assure the retention of these individuals. While we have not experienced difficulty attracting or retaining key personnel in the past, we believe that there is a limited number of available, qualified executives with relevant experience in both the insurance and capital markets industries, and our inability to hire additional senior executives or the loss of the services of any of these individuals could significantly and negatively affect our business.

We may be prohibited from doing business with certain state agencies.

The states of North Carolina and California have passed laws that prohibit state agencies from contracting with expatriate corporations and their subsidiaries, and other states are considering similar legislation. An expatriate corporation is generally defined as a corporation whose principal market for the trading of its stock is the United States, but is itself incorporated in a "tax haven" country and/or has no substantial business activities in its place of incorporation. We may meet the definition of an expatriate corporation. While ACA Financial Guaranty does not generally contract directly with state agencies when issuing its municipal bond insurance policies, to the extent we are or become subject to these laws, ACA Financial Guaranty would be prohibited from contracting with these agencies, which could have an adverse impact on our future municipal financial guaranty insurance business.

ACA Holdings is a holding company and its cash flow is dependent on payments by its subsidiaries, which are subject to various limitations imposed on them by Maryland and Bermuda law.

ACA Holdings. ACA Holdings is a holding company that conducts no operations of its own. All operations are conducted by our operating subsidiaries. As a holding company, ACA Holdings' cash flow will consist primarily of dividends, interest and other permissible payments from its subsidiaries. ACA Holdings depends on such payments to fund general corporate activities and to meet its obligations, including the payment of any dividends to its shareholders and the payment of interest and principal on its debt.

ACA Financial Guaranty. ACA Financial Guaranty is organized in the State of Maryland. Under Maryland insurance law, ACA Financial Guaranty may pay dividends without the approval of the Maryland insurance commissioner only out of earned surplus. At December 31, 2003, ACA Financial Guaranty had a negative earned surplus of approximately $53.5 million. As a result, ACA Financial Guaranty is currently unable to pay dividends. Advances or other inter-company payments by ACA Financial Guaranty may also require prior approval of the Maryland insurance commissioner, depending on the amount involved. ACA Financial Guaranty is also subject to restrictions on paying dividends under its reinsurance agreement.

Bermuda Insurance Subsidiaries. The payment of dividends by our Bermuda insurance subsidiaries, ACA Assurance, Ltd., which we refer to as ACA Bermuda, and ACA Solutions, Ltd., which we refer to as ACA Solutions, is limited under Bermuda law and regulations, including Bermuda insurance law. Under the Bermuda Insurance Act 1978, as amended, and related regulations, ACA Bermuda and ACA Solutions will be required to maintain a specified solvency margin and minimum liquidity ratio and will be prohibited from declaring or paying any dividends if to do so would cause them to fail to meet their solvency margin and minimum liquidity ratio. Under the Bermuda Insurance Act, if ACA Bermuda or ACA Solutions fails to maintain its solvency margin, it will be prohibited from declaring or paying dividends until such failure is rectified. Additionally, under the Bermuda Companies Act 1981, or the Companies Act, ACA Bermuda, ACA Solutions and the holding company of our Bermuda insurance subsidiaries may declare or pay a dividend only if, among other things, we have reasonable grounds for believing that they are, or would after the payment be, able to pay their liabilities as they become due.

Non-Insurance Subsidiaries. Funds available to us from our CDOs are limited under provisions of the borrowings we incurred to purchase the equity of the CDOs. Excess funds generated by our

CDOs and/or structuring, placement, and asset management fees are retained by our subsidiaries as collateral or are used to make required payments on these borrowings.

Our ability to conduct our business may be adversely affected by Bermuda employment restrictions.

We formed our holding company in Bermuda in 2002. Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without a work permit. None of our executive officers is a Bermudian and any such officers who will be working in Bermuda will have to do so under a work permit. We will need to obtain long-term work permits from the Bermuda authorities for any of our employees who are not Bermuda citizens and who will be working in Bermuda. The Bermuda government recently announced a new policy that places a six-year term limit on individuals with work permits, subject to certain exemptions for key employees. Our ability to conduct the business of our Bermuda subsidiaries may be adversely affected by these Bermuda employment restrictions. It is possible that we could lose the services of one or more of our key employees if we are unable to obtain their work permits, which could significantly and adversely affect our operations.

Risks Related to Our Industry

We operate our businesses in competitive environments.

The financial guaranty industry is competitive. The principal sources of direct and indirect competition are:


•	other forms of credit enhancement, including letters of credit, guaranties and credit default swaps provided primarily by banks and other financial institutions; and


•	other financial guaranty insurance companies with respect to certain segments of our business.

Competition in the financial guaranty business is based on many factors, including overall financial strength, pricing, service and evaluation by the rating agencies of financial strength. Most other financial guarantors are larger and more highly rated than we are, and have greater capital resources, name recognition and longer operating histories. If other financial guarantors or other third-party credit enhancement providers duplicate our business strategy and compete directly with us by providing comparable forms of credit enhancement to our target markets, we could be adversely affected.

The CDO market is also competitive. We compete with investment and commercial banks, investment advisory firms, private equity funds and hedge funds in the origination, structuring and managing of these structured finance products. Many of these entities have greater financial strength and are more established and well known in the CDO market than we are.

The regulatory systems under which we operate, and potential changes in regulation, could significantly and adversely affect our business.

We operate in a regulated industry, and these regulations can restrict our ability to take actions or conduct our business for the ultimate benefit of our shareholders.

ACA Holdings. ACA Holdings is subject to the insurance holding company laws of Maryland, where ACA Financial Guaranty is organized and domiciled. This law generally requires each domestic insurance company directly or indirectly owned by a holding company to register with the Maryland Insurance Commissioner and to furnish annually financial and other information. Generally, all intercompany transactions between ACA Holdings or any affiliate and the domestic insurers in the holding company system must be fair and, if material, require prior notice to and approval by the Maryland Insurance Commissioner.

ACA Financial Guaranty. ACA Financial Guaranty is organized and domiciled in Maryland and licensed, authorized or accredited to write insurance in all 50 states of the United States, the District of Columbia, Puerto Rico, the U.S. Virgin Islands and Guam. State insurance laws regulate many aspects of its insurance business and state insurance departments supervise its insurance operations.

ACA Financial Guaranty's principal insurance regulatory authority is the Maryland Insurance Commissioner. The purpose of the state insurance regulatory statutes is to protect insureds, not shareholders. Among other things, Maryland regulation requires ACA Financial Guaranty to maintain minimum levels of capital, surplus and liquidity, and imposes restrictions on payment of dividends and distributions. These statutes and regulations may, in effect, restrict the ability of ACA Financial Guaranty to write new business or, as indicated above, distribute funds to ACA Holdings. In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and some state legislators have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies.

ACA Bermuda. ACA Bermuda and ACA Solutions are registered Bermuda insurance companies and are subject to regulation and supervision in Bermuda. The applicable Bermuda statutes and regulations generally are designed to protect insureds and ceding insurance companies, not shareholders.

ACA Bermuda and ACA Solutions are not registered or licensed as insurance companies in any jurisdiction outside Bermuda. ACA Bermuda and ACA Solutions conduct their business through their offices in Bermuda and will not maintain offices, and their personnel will not conduct any insurance activities, in the U.S. or elsewhere outside of Bermuda. Although ACA Bermuda and ACA Solutions intend to conduct their business so as not to be subject to licensing requirements of any jurisdiction outside Bermuda, inquiries or challenges to ACA Bermuda's and ACA Solutions' insurance activities may be raised in the future.

The offshore insurance and reinsurance regulatory framework recently has become subject to increased scrutiny in many jurisdictions, including in the United States. In the past, there have been congressional and other proposals in the United States regarding increased supervision and regulation of the insurance industry, including proposals to supervise and regulate insurers domiciled outside the United States. If ACA Bermuda and ACA Solutions were to become subject to any insurance laws and regulations of the United States or any U.S. state, which are generally more restrictive than those applicable to them in Bermuda, at any time in the future, they might be required to post deposits or maintain minimum surplus levels and might be prohibited from engaging in lines of business or from writing specified types of policies or contracts. Complying with those laws could have a material adverse effect on our ability to conduct business or on our results of operations.

In addition, changes in laws and regulations affecting the municipal and asset-backed debt markets, as well as other governmental regulations, may subject us to additional legal liability or adversely affect the demand for financial guaranty insurance generally and/or the demand for the financial guaranty insurance that we provide. Changes in laws and regulations relating to the issuance of unregistered securities and the management of investments such as CDOs could adversely affect our ability to originate, structure and manage CDOs.

Risks Related to Taxation

U.S. corporate-level taxes may have a material adverse effect on our results of operations and your investment.

ACA Holdings, ACA Assurance Corporation, Ltd., ACA Solutions and ACA Bermuda are Bermuda companies. We intend to manage our business so that each of these companies will operate in such a manner as to avoid being treated as engaged in a trade or business within the United States and therefore generally to avoid subjecting these companies to U.S. tax (other than excise tax on premiums from insuring or reinsuring U.S. risks and withholding tax on certain U.S. source investment income). However, there is considerable uncertainty as to the activities that constitute being engaged in a trade or business within the United States, and we cannot be certain that the IRS will not contend successfully that one or more of these companies are engaged in a trade or business in the United States. If ACA Holdings or any of its foreign subsidiaries were considered to be engaged in a trade or business in the United States, we would be subject to U.S. federal corporate income and branch profits taxes on the portion of our earnings effectively connected to such U.S. trade or business, in which case our results of operations and your investment could be materially adversely affected.

A number of our subsidiaries are classified as domestic corporations for United States federal income tax purposes. They are subject to taxation by the United States at regular corporate rates with respect to their worldwide income. In addition, under U.S. federal income tax rules, our subsidiaries ACA Risk Solutions, LLC and American Capital Access Service Corporation are subject to U.S. federal income tax with respect to the net income of the Cayman special purpose entities that issue our CDO debt obligations and that they own (directly or indirectly) even if that income is not actually distributed to them. Furthermore, dividends paid by the United States subsidiaries to ACA Holdings will be subject to a 30% U.S. federal withholding tax.

Additional taxes may be imposed if ACA Holdings or any of its subsidiaries is classified as a personal holding company, or a PHC.

It is possible that ACA Holdings and/or any of its subsidiaries could be classified as PHCs and subjected to additional tax on their undistributed personal holding company income. See "Material U.S. Federal Income Tax and Bermuda Tax Considerations – United States – Personal Holding Companies" for a description of the factors that could cause us to be classified as a PHC. These factors relate generally to concentration of actual or constructive ownership of stock in five or fewer individuals and receipt of passive income above a threshold. Prior to consummation of this offering, ownership of ACA Holdings shares are concentrated in this manner, and the passive income of ACA Holdings exceeded the statutory threshold in 2003.

We do not expect that ACA Holdings or any of its subsidiaries will satisfy the PHC stock ownership concentration test immediately following the offering, but there can be no assurance that the information provided by our shareholders or available to us upon which this expectation is based is accurate, and such information is not complete in all respects. We also intend to manage the business of ACA Holdings so as to reduce the risk that the PHC passive income test will be satisfied in the future, although we cannot be certain that we will succeed in doing so. More generally, we cannot be certain that ACA Holdings or any of its subsidiaries will not be PHCs following the offering or in the future because of factors including legal and factual uncertainties regarding the application of the constructive ownership rules, the makeup of ACA Holdings' shareholder base, the gross income of ACA Holdings or any of its subsidiaries and other circumstances that could affect the application of the PHC rules to ACA Holdings and/or its subsidiaries.

If you own or are deemed to own 10% or more of ACA Holdings' shares, you may be subject to taxation under the controlled foreign corporation, or CFC, rules.

Prior to the consummation of this offering, ACA Holdings, ACA Assurance Corporation, Ltd., ACA Bermuda and ACA Solutions are CFCs. Each "10% U.S. Shareholder" of a CFC may have to pay U.S. income tax on such shareholder's pro rata share of all or a significant portion of the CFC's income, even if that income is not distributed. A foreign corporation is considered a CFC if "10% U.S. Shareholders" own (directly, indirectly or constructively) more than 50% of the total combined voting power or value of all classes of its voting stock. A foreign insurance company such as ACA Bermuda (or ACA Solutions) is treated as a CFC if "10% U.S. Shareholders" collectively own (through ACA Holdings) more than 25% of the total combined voting power or total value of ACA Bermuda's (or ACA Solutions') shares. A "10% U.S. Shareholder" is a U.S. Person (as defined in "Material U.S. Federal Income Tax and Bermuda Tax Considerations – Taxation of Shareholders – United States Taxation – Classification of ACA Holdings or its Foreign Subsidiaries as Controlled Foreign Corporations") who owns (directly, indirectly or constructively) 10% or more of the total combined voting power of all classes of stock entitled to vote.

Upon consummation of the offering, one or more U.S. Persons are expected to still own 10% or more of our common shares. Those persons will collectively still own more than 25% of our common shares, and they may collectively own more than 50% of our common shares. Our bye-laws contain provisions (described in "Description of Our Share Capital") that (i) limit to approximately 9.9% the voting power of any U.S. Person who owns or is deemed to own 10% or more of our common shares, and (ii) require the board of directors of ACA Holdings to submit to the shareholders of ACA Holdings any matter that requires ACA Holdings to vote the shares of a non-U.S. subsidiary. These provisions are intended to prevent U.S. Persons who own 10% or more of our shares from being

treated for U.S. federal income tax purposes as 10% U.S. Shareholders and to prevent ACA Holdings, ACA Assurance Corporation, Ltd., ACA Bermuda and ACA Solutions from being classified as CFCs, but it is not clear whether the provisions will accomplish these objectives. Accordingly, U.S. Persons who directly, indirectly or constructively own or are deemed to own 10% or more of our common shares should consider the possible application of the CFC rules.

Additional provisions in our bye-laws (also described in "Description of Our Share Capital") prohibit any issuance, transfer or redemption of shares that would have the effect of generally causing any person to become an owner of 10% or more of our common shares. If these provisions are followed, investors purchasing common shares in this offering generally should not be 10% U.S. Shareholders. Subject to the possible application of the RPII provisions discussed below, an investor who is not a 10% U.S. Shareholder should not be required by the CFC rules to include in income a portion of our undistributed passive and insurance income regardless of whether ACA Holdings or its Bermuda subsidiaries are classified as CFCs.

We and some of our subsidiaries each may be considered to be a foreign personal holding company, or a FPHC, for U.S. federal income tax purposes, and U.S. persons who hold common shares will be subject to adverse tax consequences if we are or a subsidiary is an FPHC.

A foreign corporation will be classified as an FPHC with respect to a taxable year for U.S. federal income tax purposes if (i) at any time during the taxable year, five or fewer individuals who are U.S. citizens or residents (referred to as the "United States group") own (actually or constructively) more than 50% of all classes of the corporation's stock measured by voting power or value (the "stock ownership test") and (ii) certain passive income thresholds are met by the corporation (the "passive income test"). If a foreign corporation is classified as an FPHC with respect to a taxable year, each U.S. Person who owns (directly or through other foreign entities) shares of the foreign corporation on the day of the taxable year of the corporation that was the last day on which a "United States group" existed with respect to the corporation must include in income such U.S. person's pro rata share of the "undistributed foreign personal holding company income" (defined as taxable income with certain adjustments) of the foreign corporation.

Prior to this offering, ACA Holdings and its foreign subsidiaries have satisfied the stock ownership test for classification as an FPHC. During 2003, ACA Holdings and certain foreign subsidiaries have had sufficient passive income that they have also satisfied the passive income test and therefore have been classified as FPHCs. However, we expect that, immediately following the consummation of the offering, 50% or more of the stock of ACA Holdings will not be owned or deemed owned by five or fewer individuals and that a "United States group" will no longer exist with respect to ACA Holdings and its subsidiaries immediately following completion of the offering. There can be no assurance, however, that the information provided by our shareholders or made available to us on which we base this expectation is accurate, and such information is not complete in all respects. Because a "United States group" will have existed for the portion of 2004 preceding completion of the offering, the stock ownership test for FPHC status will nevertheless be satisfied for 2004. We intend, however, to manage the business of ACA Holdings and its Bermuda subsidiaries so as to reduce the risk that the passive income test will be satisfied for 2004 with respect to ACA Holdings and its Bermuda subsidiaries and thereby to reduce the risk that ACA Holdings and its Bermuda subsidiaries will be FPHCs for 2004. We cannot be certain, however, that we will be successful in doing so.

Provided that no "United States group" exists in 2005 and subsequent years, ACA Holdings and its foreign subsidiaries will not be FPHCs. In addition, we intend to continue managing the business of ACA Holdings and its foreign subsidiaries (other than the Cayman special purpose entities) so as to reduce the risk that the passive income test will be satisfied. We cannot be certain, however, that changes in share ownership subsequent to the offering may not cause ACA Holdings and its foreign subsidiaries to again satisfy the stock ownership test, so that a "United States group" again exists; nor can we be certain that we will not satisfy the passive income test in the future. More generally, we cannot be certain that ACA Holdings or any of its foreign subsidiaries will not be considered an FPHC because of various factors including legal and factual uncertainties regarding the application of the constructive ownership rules, the makeup of ACA Holdings' shareholder base, the gross income

of ACA Holdings and/or any of its foreign subsidiaries and other circumstances that could affect the application of the FPHC rules to ACA Holdings and its foreign subsidiaries.

We may be considered a passive foreign investment company, or a PFIC, for U.S. federal income tax purposes, and U.S. persons who hold common shares will be subject to adverse tax consequences if we are a PFIC.

A foreign corporation will constitute a PFIC with respect to a taxable year if 75% or more of its gross income for that taxable year consists of passive income, or 50% or more of its average assets held during that taxable year consist of passive assets. We were a PFIC in 2003. If we were considered a PFIC in 2004 or subsequent years, it could have material adverse tax consequences for an investor that is subject to U.S. federal income taxation, including subjecting the investor to a greater U.S. tax liability, including payments of interest, than might otherwise apply and subjecting the investor to tax on amounts in advance of when tax would otherwise be imposed. We have taken steps in 2004 to seek to avoid classification as a PFIC, primarily by taking advantage of a complex rule, contained in the PFIC provisions of the Internal Revenue Code of 1986, as amended, or the Internal Revenue Code, involving our corporate structure, described further in "Material U.S. Federal Income Tax and Bermuda Tax Considerations – Taxation of Shareholders – United States Taxation – Passive Foreign Investment Companies" below.

The rule upon which we are relying to avoid PFIC classification will not be available to us in any year if we are a PHC or an FPHC in that year, and we cannot be certain that we will not be a PHC or FPHC in 2004 or any subsequent year. If we are a PHC or an FPHC, we will be a PFIC. Moreover, there are substantial uncertainties regarding the manner in which the PFIC rules generally, and the rule upon which we are relying in particular, are to be interpreted and applied. It is possible that the IRS will take a position that we are a PFIC, and a court may sustain such position. Furthermore, it should be noted that, in early 2003, legislation was proposed in the U.S. Congress that would have eliminated the rule upon which we are relying. The proposed legislation was not enacted, but no assurance can be given that similar legislation might not be proposed or enacted in the future. Any prospective investor considering an investment in our common shares is urged to consult his tax advisor regarding these uncertainties.

U.S. holders of common shares may be required to pay U.S. federal income taxes on their pro rata share of ACA Bermuda's or ACA Solutions' "related person insurance income."

A foreign insurance company's related person insurance income, or RPII, is its insurance income attributable to policies of insurance or reinsurance with respect to which the person directly or indirectly insured is either (i) a U.S. person who is a shareholder (directly or indirectly through foreign entities) of the insurer or (ii) a person related to that U.S. shareholder. If the RPII of ACA Bermuda (or ACA Solutions) were to equal or exceed 20% of its gross insurance income in any taxable year and direct or indirect insureds (and persons related to such insureds) own (directly or indirectly) 20% or more of the voting power or value of the shares of ACA Bermuda (or ACA Solutions), then a U.S. person who owns any common shares of ACA Holdings (directly or indirectly through foreign entities) on the last day of the taxable year would be required to include in its income for U.S. federal income tax purposes the shareholder's pro rata share of ACA Bermuda's (or ACA Solutions') RPII for the entire taxable year, determined as if RPII were distributed proportionately to those U.S. shareholders at that date regardless of whether it is distributed. U.S. tax-exempt organizations would be required to treat RPII as unrelated business taxable income.

While there can be no assurance on this point because of the difficulties, described below, in applying the RPII rules, we currently have no reason to believe that, in the foreseeable future, 20% or more of the gross insurance income of ACA Bermuda (or ACA Solutions) will be determined to be RPII. It may be difficult or impossible for us to establish whether or not we satisfy either the 20% gross income exception or the 20% ownership exception in the future, and we may fail to satisfy either or both of these exceptions because of events beyond our control. For example, when we reinsure risks insured by unrelated insurance companies, we often do not know the identity of the person or persons who are covered by the primary insurance and who are therefore indirectly covered by our reinsurance. Accordingly, we often do not have information necessary to determine whether or to

what extent our reinsurance policies indirectly insure persons who are shareholders of ACA Holdings or are "related persons" with respect to shareholders of ACA Holdings, and we therefore cannot ascertain whether or to what extent our income from such reinsurance is RPII. As another example, our financial guaranty insurance protects the holders of insured obligations against payment defaults on the part of the issuers of those obligations. The insured obligations are sometimes publicly traded. Accordingly, it may be difficult or impossible for us to ascertain the degree of overlap (which may change from time to time) between our "insureds" (i.e., the holders of debt obligations insured or reinsured by ACA Bermuda or ACA Solutions) and our shareholders or persons related to our shareholders. We are not aware of any IRS rulings or other authority providing guidance as to the manner in which the RPII rules are to be applied in these circumstances.

U.S. tax-exempt organizations who own our common shares may recognize unrelated business taxable income.

A U.S. tax-exempt organization may recognize unrelated business taxable income if a portion of our insurance income is allocated to the organization. In general, insurance income will be allocated to a U.S. tax-exempt organization if either we are a CFC and the tax-exempt shareholder is a U.S. 10% Shareholder or there is RPII and certain exceptions do not apply. Potential U.S. tax-exempt investors are advised to consult their own tax advisors.

Changes in U.S. federal income tax law could materially adversely affect shareholders' investments.

Legislation has been introduced in the U.S. Congress intended to eliminate tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have certain U.S. connections. In this regard, legislation has been introduced that affects the U.S. tax treatment of foreign corporations that are deemed to have "inverted" and that includes provisions that would permit the IRS to reallocate or recharacterize items of income, deduction or certain other items related to a reinsurance agreement between related parties to reflect the proper source, character and amount for each item (in contrast to current law, which only refers to source and character). Other legislation would provide additional limits on the deductibility of interest by foreign owned U.S. companies. As noted earlier, legislation was proposed in the U.S. Congress early in 2003 but not enacted that would have eliminated the statutory rule upon which we intend to rely to avoid being classified as a PFIC. We cannot predict whether this or other restrictive legislation may be enacted or, if enacted, what the specific provisions or effective date of any such legislation would be, or what effect it might have on us or our subsidiaries.

Additionally, U.S. federal income tax laws and interpretations thereof with respect to a number of issues potentially important to us and our subsidiaries – including such matters as the rules for determining whether a company is engaged in a trade or business within the United States, whether a company is a PFIC and whether and in what manner the rules relating to controlled foreign corporations apply – are uncertain in many respects and are subject to change, possibly on a retroactive basis. We cannot be certain if, when or in what form future regulations or other pronouncements may be provided or implemented and whether such guidance will have retroactive effect.

We may become subject to taxes in Bermuda after 2016.

We have received a standard assurance from the Bermuda Minister of Finance, under Bermuda's Exempted Undertakings Tax Protection Act 1966, that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to us or to any of our operations or our shares, debentures or other obligations until March 28, 2016. Consequently, if our Bermuda tax exemption is not extended past March 28, 2016, we may be subject to any Bermuda tax after that date.

Bermuda could be subject to sanctions by a number of multinational organizations, which could adversely affect Bermuda companies.

A number of multinational organizations, including the European Union, the Organization for Economic Cooperation and Development, or the OECD, including its Financial Action Task Force,

and the Financial Stability Forum have all recently identified certain countries as blocking information exchange, engaging in harmful tax competition or not maintaining adequate controls to prevent corruption, such as money laundering activities. Recommendations to limit such harmful practices are under consideration by these organizations, and a recent report published on November 27, 2001 by the OECD contains an extensive discussion of specific recommendations. The OECD has threatened non-member jurisdictions that do not agree to cooperate with the OECD with punitive sanctions by OECD member countries. It is unclear what these sanctions will be and if they will be imposed. Bermuda has committed to a course of action to enable compliance with the requirements of these multinational organizations. However, the action taken by Bermuda may not be sufficient to preclude all effects of the measures or sanctions described above, which if ultimately adopted could adversely affect Bermuda companies such as ACA Holdings and ACA Bermuda.

Risks Related to the Offering and our Common Shares

If a substantial number of our common shares become available for sale and are sold in a short period of time, the market price of our common shares could decline.

If our existing shareholders sell substantial amounts of our common shares in the public market following the consummation of this offering, the market price of our common shares could decrease significantly. The perception in the public market that our existing shareholders might sell our common shares could also depress our market price. Upon consummation of this offering we will have of our common shares outstanding, assuming no exercise of the underwriters' over-allotment option. Our directors, officers and most of our existing shareholders will be subject to agreements with the underwriters that restrict their ability to transfer their shares for a period of 180 days from the date of this prospectus, subject to a few exceptions. After all of these agreements expire, an aggregate of additional shares will be eligible for sale in the public market. However, the underwriters may waive these restrictions and allow these shareholders to sell their shares at any time. In addition, options for approximately of our common shares will be exercisable. Upon the consummation of this offering, the holders of most of our currently outstanding common shares and their transferees will have the right to require us to register their common shares under the Securities Act of 1933, or the Securities Act, for sale into the public markets, subject to the 180-day lock-up agreements. Upon the effectiveness of any such registration statement, all shares covered by the registration statement will be freely transferable. In addition, within 90 days following the consummation of this offering we intend to file one or more registration statements on Form S-8 under the Securities Act to register common shares issued or reserved for issuance under our Omnibus Incentive Compensation Plan. Subject to the exercise of issued and outstanding options, shares registered under the registration statement on Form S-8 will be available for sale into the public markets after the expiration of the 180-day lock-up agreements. The market price of our common shares may drop significantly when the restrictions on resale by our directors, officers and existing shareholders lapse.

If you purchase the common shares sold in this offering, you will experience immediate dilution.

If you purchase our common shares in this offering, you will experience immediate dilution of $ per share, because the price that you pay will be greater than the net tangible book value per share of the shares you acquire. This dilution is due in large part to the fact that our earlier investors paid substantially less than the initial public offering price when they purchased their shares. You will experience additional dilution upon the exercise of outstanding stock options to purchase common shares.

We do not currently intend to pay dividends in the foreseeable future.

It is uncertain when, if ever, we will declare dividends to our shareholders. During the next few years of operations, we expect that we will retain virtually all profit. Our ability to pay dividends may be constrained by our holding company structure under which we are dependent on payments by our subsidiaries, which are subject to limitations imposed on them by Maryland and Bermuda law, as discussed above. You should not rely on an investment in us if you require dividend income. In the foreseeable future, the only possible return on an investment in us would come from an appreciation of our common shares.

Insiders will continue to have substantial control over us after this offering and could limit your ability to influence the outcome of key transactions, including a change of control.

Our directors, executive officers and principal shareholders and entities affiliated with them will own approximately % of our outstanding common shares after this offering. As a result, these shareholders, if acting together, would be able to influence or control matters requiring approval by our shareholders, including the election of directors and the approval of mergers or other fundamental transactions. They may also have interests that differ from yours and may vote in a way with which you disagree and which may be adverse to your interests. The concentration of ownership may have the effect of delaying, preventing or deterring a change of control of our company, could deprive our shareholders of an opportunity to receive a premium for their common shares as part of a sale of our company and might ultimately affect the market price of our common shares.

It may be difficult to effect service of process and to enforce judgments against us and our officers and directors in the future.

ACA Holdings is a Bermuda company. In the future, certain of our officers and directors may not be residents of the United States and a substantial portion of our assets may ultimately be located in jurisdictions outside the U.S. As a result, it may become difficult for investors to effect service of process within the U.S. on our directors and officers who reside outside the U.S. or to enforce against us or our directors and officers judgments of U.S. courts predicated upon civil liability provisions of the U.S. federal securities laws. We have been advised by our Bermuda counsel, Conyers Dill & Pearman, that uncertainty exists as to whether courts in Bermuda will enforce judgments obtained in other jurisdictions, including the United States, against us or our directors or officers under the laws of those jurisdictions or entertain actions in Bermuda against us or our directors or officers under the securities laws of other jurisdictions including actions for claims under U.S. federal securities laws.

There are limitations on the ownership, transfer and voting rights of ACA Holdings' common shares.

Under the bye-laws of ACA Holdings, directors of ACA Holdings may decline to register any transfer of common shares that would result in a person (or any group of which such person is a member) beneficially owning, directly or indirectly, 10% or more of the voting shares or the total combined value of ACA Holdings' issued shares. Similar restrictions apply to ACA Holdings' ability to issue or repurchase shares. The directors also may, in their discretion, decline to register the transfer of any shares if they have reason to believe (1) that the transfer may lead to adverse tax or regulatory consequences in any jurisdiction or (2) that the transfer would violate the registration requirements of the U.S. federal securities laws or of any other jurisdiction. These restrictions would apply to a transfer of shares even if the transfer has been executed on the NYSE. A transferor of common shares will be deemed to own those shares for dividend, voting and reporting purposes until a transfer of those common shares has been registered on ACA Holdings' register of shareholders. ACA Holdings is authorized to request information from any holder or prospective acquiror of common shares as necessary to give effect to the transfer, issuance and repurchase restrictions referred to above, and may decline to effect any transaction if complete and accurate information is not received as requested.

In addition, ACA Holdings' bye-laws generally provide that any person (or any group of which such person is a member) beneficially owning, directly or indirectly, shares carrying 10% or more of the total voting rights attached to all of our outstanding voting shares, will have the voting rights attached to its issued shares reduced so that it may not exercise more than 9.9% of such total voting rights. Because of the attribution provisions of the Internal Revenue Code, this requirement may have the effect of reducing the voting rights of a shareholder whether or not such shareholder directly holds 10% or more of ACA Holdings' common shares. Further, the directors have the authority to require from any shareholder certain information for the purpose of determining whether that shareholder's voting rights are to be reduced. Failure to respond to such a notice, or submitting incomplete or inaccurate information, gives the directors discretion to disregard all votes attached to that shareholder's common shares.

The insurance law of Maryland prevents any person from acquiring control of ACA Holdings or of ACA Financial Guaranty unless that person has filed a notification with specified information with

the Maryland Insurance Commissioner and has obtained his or her prior approval. Under the Maryland statute, acquiring 10% or more of the voting stock of an insurance company or its parent company is presumptively considered a change of control, although such presumption may be rebutted. Accordingly, any person who acquires, directly or indirectly, 10% or more of the voting securities of ACA Holdings without the prior approval of the Maryland Insurance Commissioner will be in violation of this law and may be subject to injunctive action requiring the disposition or seizure of those securities by the Maryland Insurance Commissioner or prohibiting the voting of those securities and to other actions determined by the Maryland Insurance Commissioner. In addition, many U.S. state insurance laws require prior notification of state insurance departments of a change in control of a non-domiciliary insurance company doing business in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove the change in control, they authorize regulatory action, including revocation of ACA Financial Guaranty's license, in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of ACA Holdings may require prior notification in those states that have adopted preacquisition notification laws. Given the importance of ACA Financial Guaranty's "A" rating to our business, as a practical matter, a change of control would require confirmation in advance from the rating agencies that such transaction would not result in a downgrading of the financial strength rating assigned to ACA Financial Guaranty.

The foregoing provisions of ACA Holdings' bye-laws and legal restrictions will have the effect of rendering more difficult or discouraging unsolicited takeover bids from third parties or the removal of incumbent management.

U.S. persons who own our common shares may have more difficulty in protecting their interests than U.S. persons who are shareholders of a U.S. corporation.

The Companies Act, which applies to us, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. Set forth below is a summary of certain significant provisions of the Companies Act, which includes, where relevant, information on modifications thereto adopted pursuant to our bye-laws, applicable to us, which differ in certain respects from provisions of Delaware corporate law. Because the following statements are summaries, they do not discuss all aspects of Bermuda law that may be relevant to us and our shareholders.

Interested Directors. Bermuda law provides that we cannot void any transaction we enter into in which a director has an interest, nor can such director be liable to us for any profit realized pursuant to such transaction, provided the nature of the interest is disclosed at the first opportunity at a meeting of directors, or in writing to the directors. Under Delaware law such transaction would not be voidable solely because a director has an interest in the transaction or solely because the director participates in the board meeting that authorizes such transaction or solely because such director's vote is counted for such purpose, if:


•	The material facts as to such interested director's relationship or interests were disclosed or were known to the board of directors and the board had in good faith authorized the transaction by the affirmative vote of a majority of the disinterested directors;


•	Such material facts were disclosed or were known to the shareholders entitled to vote on such transaction and the transaction was specifically approved in good faith by vote of the shareholders; or


•	The transaction was fair as to the corporation as of the time it was authorized, approved or ratified by the board or the shareholders.

Under Delaware law, the interested director could be held liable for a transaction in which the director derived an improper personal benefit.

Business Combinations with Large Shareholders or Affiliates. As a Bermuda company, we may enter into business combinations with our large shareholders or affiliates, including mergers, asset sales and other transactions in which a large shareholder or affiliate receives, or could receive, a financial benefit that is greater than that received, or to be received, by other shareholders, without

obtaining prior approval from our board of directors or from our shareholders. If we were a Delaware company, we would need prior approval from our board of directors or a supermajority of our shareholders to enter into a business combination with an interested shareholder for a period of three years from the time the person became an interested shareholder, unless we opted out of the relevant Delaware statute.

Shareholders' Suits. The rights of shareholders under Bermuda law are not as extensive as the rights of shareholders in many United States jurisdictions. Class actions and derivative actions are generally not available to shareholders under the laws of Bermuda. However, the Bermuda courts ordinarily would be expected to follow English case law precedent, which would permit a shareholder to commence an action in the name of the company to remedy a wrong done to the company where an act is alleged to be beyond the corporate power of the company, is illegal or would result in the violation of our memorandum of continuance or bye-laws. Furthermore, the court would consider acts that are alleged to constitute a fraud against the minority shareholders or where an act requires the approval of a greater percentage of our shareholders than actually approved it. The winning party in such an action generally would be able to recover a portion of attorneys' fees incurred in connection with such action. Our bye-laws provide that shareholders waive all claims or rights of action that they might have, individually or in the right of the company, against any director or officer for any act or failure to act in the performance of such director's or officer's duties, except with respect to any fraud or dishonesty of such director or officer. Class actions and derivative actions generally are available to shareholders under Delaware law for, among other things, breach of fiduciary duty, corporate waste and actions not taken in accordance with applicable law. In such actions, the court has discretion to permit the winning party to recover attorneys' fees incurred in connection with such action.

Indemnification of Directors and Officers. We may indemnify our directors or officers, or any person appointed to any committee by the Board acting in their capacity as such, in relation to any of our affairs for any loss, damages or expenses (including attorneys' fees) arising or liability attaching to them by virtue of any rule of law in respect of any negligence, default, breach of duty or breach of trust of which such person may be guilty in relation to the company other than in respect of his own fraud or dishonesty. Indemnification permitted under Delaware law is more limited. Under Delaware law, a corporation may indemnify a director or officer of the corporation against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred in defense of an action, suit or proceeding by reason of such position, if such director or officer acted in good faith and in a manner he or she reasonably believed to be in or not to be opposed to the best interests of the corporation and, with respect to any criminal action or proceeding, such director or officer had no reasonable cause to believe his or her conduct was unlawful.

For more information on the differences between Bermuda and Delaware corporate laws, see "Description of Our Share Capital—Differences in Corporate Law."

We may require you to sell your common shares to us.

Under our bye-laws and subject to Bermuda law, we have the option, but not the obligation, to require a shareholder to sell some or all of its common shares to us at their fair market value if the board of directors reasonably determines, in its absolute discretion, that share ownership, directly, indirectly or constructively by any shareholder is likely to result in adverse tax, regulatory or legal consequences to us, certain of our other shareholders or our subsidiaries.

Anti-takeover provisions in our bye-laws could impede an attempt to replace or remove our directors, which could diminish the value of our common shares.

Our bye-laws contain provisions that may entrench directors and make it more difficult for shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a shareholder might consider favorable. For example, these provisions may prevent a shareholder from receiving the benefit from any premium over the market price of our common shares offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging takeover attempts in the future.

For example, our bye-laws contain the following provisions that could have such an effect:


•	election of our directors is staggered, meaning that the members of only one of three classes of our directors are selected each year;


•	shareholders have limited ability to remove directors;


•	the total voting power of any shareholder owning 10% or more of our common shares will be reduced to less than 10% of the total voting power of our common shares;

•

our directors may decline to register the transfer of any common shares on our share register if it appears to the board of directors, in their sole and reasonable discretion, after taking into account the limitations on voting rights contained in our bye-laws, that any adverse tax, regulatory or legal consequences to us, any person ceding insurance to us, any of our subsidiaries or any shareholder, would result from such transfer; and


•	subject to any applicable requirements of the NYSE, our directors may decline to record the transfer of any common shares on our share register unless all approvals from appropriate governmental authorities in Bermuda, the United States or any other applicable jurisdiction required to be obtained prior to such transfer have been obtained.

Management has discretion to use unallocated net proceeds.

We have not designated a specific use for the net proceeds to our company from the sale of common shares in this offering. We expect to use the net proceeds of this offering for general corporate purposes. Consequently, the board of directors and management of our company will have broad discretion in allocating the net proceeds to our company from this offering.

FORWARD-LOOKING STATEMENTS AND PROJECTIONS

This prospectus contains forward-looking statements. Forward-looking statements relate to future events or our future financial performance. We generally identify forward-looking statements by terminology such as "may," "will," "should," "expects," "plans," "anticipates," "could," "intends," "target," "projects," "contemplates," "believes," "estimates," "predicts," "potential" or "continue" or the negative of these terms or other similar words. These statements are only predictions. The outcome of the events described in these forward-looking statements is subject to known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from what is expressed or implied by these forward-looking statements. The "Risk Factors" section and those sections entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business" as well as other sections in this prospectus discuss some of the factors that could contribute to these differences.

The forward-looking statements made in this prospectus relate only to events as of the date on which the statements are made. Except as may be required under the U.S. securities laws, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

This prospectus also contains market data related to our business and industry. These market data include projections that are based on a number of assumptions. If these assumptions turn out to be incorrect, actual results may differ from the projections based on these assumptions. As a result, our markets may not grow at the rates projected by these data, or at all. The failure of these markets to grow at these projected rates may have a material adverse effect on our business, results of operations and financial condition, and the market price of our common shares.

The Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act, each of which provide protection in connection with certain forward-looking statements, do not directly protect any statements we make in connection with this offering.

USE OF PROCEEDS

We estimate that our net proceeds from the initial public offering of our common shares, after deducting the underwriting discounts and commissions and our estimated offering expenses, will be approximately $ million. We estimate that our net proceeds will be approximately $ million if the underwriters exercise their over-allotment option in full. We intend to use the net proceeds of this offering for general corporate purposes.

DIVIDEND POLICY

Following the consummation of this offering, we intend to retain all available funds for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Any determination to pay cash dividends will be at the discretion of our board of directors and will be dependent upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and any other factors our board of directors deems relevant.

We are a holding company and have no direct operations. Our ability to pay dividends depends, in part, on the ability of our subsidiaries to pay dividends to us. Our subsidiaries are subject to significant regulatory and contractual restrictions limiting their ability to declare and pay dividends. As of December 31, 2003, ACA Financial Guaranty had a negative earned surplus in the amount of $53.5 million. Applicable insurance laws would prohibit ACA Financial Guaranty from paying dividends without the approval of the Maryland insurance commissioner until it has a positive earned surplus calculated on a SAP basis.

Additionally, we are subject to Bermuda regulatory constraints that will affect our ability to pay dividends on our common shares and make other payments. Under the Companies Act, we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment be, able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts.

In addition, under the terms of our trust preferred securities, we may not pay common dividends in any period in which we elect to defer payment of interest on the trust preferred securities.

For more information regarding restrictions on the payment of dividends by us and our subsidiaries, see "Regulation—Dividends" and "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources."

CAPITALIZATION

The following table sets forth our capitalization as of December 31, 2003:


•	on an actual basis; and

•

on an as adjusted basis to reflect the automatic conversion of all outstanding convertible preference shares and all outstanding senior convertible preferred shares into 6,235,929 common shares immediately prior to the consummation of this offering and to give effect to the receipt of approximately $ million in estimated net proceeds from the sale of common shares in this offering, assuming an initial public offering price of $ per share, the midpoint of the range on the cover of this prospectus and assuming no exercise of the underwriters' over-allotment option.


	December 31, 2003
	Actual(1)(2)			As Adjusted(1)
	(dollars in thousands)
Trust preferred debt	$	59,280		$
CDO-related debt(3)		2,905,052
Total debt(3)		2,964,332
Shareholder's equity:
Senior convertible preferred shares		7,339			—
Convertible preference shares		54,858
Common shares, $0.0177 par value; authorized 149,998,280 shares; issued and fully paid 6,045,635, actual, as adjusted		107
Gross paid-in and contributed capital		125,721
Treasury shares		(3,222	)
Notes receivable from shareholders		(4,200	)
Accumulated other comprehensive income		751
Retained earnings		12,952
Total shareholders' equity		194,306
Total capitalization(3)	$	3,158,638		$

(1)	Excludes 2,015,212 common shares that may be issued pursuant to outstanding options as of December 31, 2003 at a weighted average exercise price of $11.44 per share.

(2)	Excludes common shares issuable upon the exercise of stock options to be issued upon the consummation of this offering, at an exercise price equal to the initial public offering price set forth on the cover page of this prospectus.

(3)	Represents debt related to our CDOs. Includes $2,804 million of debt issued by our CDOs which is solely the obligation of the entities which issue the CDOs. Excluding such debt, total debt would be $159.5 million and total capitalization would be $353.9 million.

DILUTION

Dilution per share represents the amount by which the price per share paid by purchasers of common shares in this initial public offering exceeds the net tangible book value per common share immediately after completion of this offering. Net tangible book value per common share at December 31, 2003 was $32.18. After giving effect to the automatic conversion of all outstanding convertible preference shares and all outstanding senior convertible preferred shares into common shares immediately prior to the consummation of this offering the pro forma net tangible book value of our common shares as of December 31, 2003 was $189.4 million, or approximately $15.63 per share. Pro forma net tangible book value per share represents our total tangible assets less total liabilities, divided by the pro forma number of common shares outstanding. After giving effect to the sale of common shares by us at an assumed initial public offering price of $ per share, the mid-point of the price range set forth on the cover of this prospectus, and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us, our pro forma as adjusted net tangible book value as of December 31, 2003 would have been $ , or approximately $ per common share. This represents an immediate increase in pro forma net tangible book value of $ per common share to existing shareholders and an immediate dilution in adjusted net tangible book value of $ per share to new investors purchasing common shares in this offering.

The following table illustrates this per share dilution:


Assumed initial public offering price per share	$
Pro forma net tangible book value per share as of December 31, 2003	$	15.63
Increase in pro forma net tangible book value per share attributable to new investors	$
Pro forma net tangible book value per share after this offering	$
Dilution per share to new investors	$

The following table summarizes, as of December 31, 2003, on the pro forma basis described above, the difference between existing shareholders and new investors with respect to the number of common shares purchased from us, the total consideration paid to us and the average price per share paid by our existing shareholders and by the investors purchasing common shares in this offering. The calculation below is based on an assumed initial public offering price of $ per share before deducting underwriting discounts and commissions and estimated offering expenses payable by us.


	Shares Purchased				Total Consideration				Average Price
	Number	Percent			Amount	Percent			Per Share
Existing shareholders				%	$			%	$
New investors
Total			100.0	%	$		100.0	%	$

The share amounts in this table exclude 2,015,212 of our common shares that were subject to outstanding options granted under our Omnibus Incentive Compensation Plan as of December 31, 2003 at a weighted average exercise price of $11.44 per common share. The amount of shares and exercise price have been adjusted to reflect a share split which we expect to effect prior to the consummation of the offering. To the extent that any options are exercised, there will be further dilution to new investors. If all of our outstanding options as of December 31, 2003 had been exercised, the pro forma net tangible book value per share after this offering would be $ per share, representing an immediate increase in pro forma net tangible book value of $ per share to our existing shareholders and an immediate decrease in the pro forma net tangible book value to our new investors of $ .

If the underwriters exercise their over-allotment option in full, the number of shares held by new investors will increase to , or % of the total number of common shares outstanding after this offering and the dilution per share to new investors will be $ .

SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA

The following table sets forth historical consolidated financial and other data as of and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999. We derived our selected consolidated financial data as of and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 from our audited consolidated financial statements, which have been prepared in accordance with U.S. GAAP and audited by PricewaterhouseCoopers LLP, our independent auditors. Our historical results are not necessarily indicative of our results for any future period. You should read the data set forth below in conjunction with our consolidated financial statements and related notes, and "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information appearing elsewhere in this prospectus.


	For the Year Ended
	Dec. 31,		Dec. 31,			Dec. 31,		Dec. 31,			Dec. 31,
	2003		2002			2001		2000			1999
	(in thousands, except per share amounts)
Income Statement Data:
Gross premiums written	$	66,014	$	55,264		$	23,021	$	43,786		$	47,493
Net premiums written		62,549		47,434			5,459		29,920			41,409
Premiums earned		23,836		13,976			6,672		6,869			6,474
Net investment income		52,868		20,269			11,567		9,653			7,400
Net realized gains (losses)		3,188		4,138			6,511		(11	)		(100	)
Net realized and unrealized gains (losses) on derivative instruments		6,821		(8,666	)		—		—			—
Derivative income		11,972		4,975			—		—			—
Fee income		8,898		4,236			194		833			215
Other income		423		676			—		226			813
Total revenues		108,006		39,604			24,944		17,570			14,802
Loss and loss adjustment expenses		3,168		1,801			1,636		1,332			937
Policy acquisition costs		4,077		4,046			3,680		4,676			2,213
Other operating expenses		29,466		18,683			14,304		12,806			11,399
Interest expense		42,046		9,869			126		25			—
Depreciation and amortization		1,329		1,081			730		852			—
Reorganization costs		—		—			1,749		3,130			—
Total expenses		80,086		35,480			22,225		22,821			14,549
Income (loss) before income taxes		27,920		4,124			2,719		(5,251	)		253
Provision (benefit) for income taxes		10,717		(444	)		110		130			—
Net income (loss)	$	17,203	$	4,568		$	2,609	$	(5,381	)	$	253
Basic earnings (loss) per share	$	2.92	$	0.77		$	0.45	$	(0.97	)	$	0.04
Diluted earnings (loss) per share		1.37		0.37			0.23		(0.97	)		0.04
Weighted average number of common shares outstanding:
Basic		5,886		5,895			5,786		5.561			5,630
Diluted		12,559		12,268			11,136		5,561			5,630



	Dec. 31,		Dec. 31,		Dec. 31,		Dec. 31,		Dec. 31,
	2003		2002		2001		2000		1999
	(In thousands, except share amounts)
Summary Balance Sheet Data:
Cash and investments(a)	$	3,321,690	$	808,545	$	231,672	$	185,376	$	157,392
Total assets(a)		3,468,426		916,966		299,062		235,002		196,304
Reserve for losses and loss adjustment expenses		9,547		6,555		3,405		2,675		1,343
Unearned premiums		172,337		136,222		101,208		96,654		70,918
Total debt (a)		2,964,332		541,470		825		—		—
Total liabilities		3,274,120		757,106		128,144		108,048		82,305
Total shareholders' equity		194,306		159,860		170,918		126,954		113,999
Per Share Data:
Book value per share (b)	$	16.03	$	13.23	$	14.38	$	18.03	$	20.25
Other Data (c):
Net par exposure (in millions)	$	8,563	$	6,378	$	5,563	$	5,447	$	5,327
CDO assets under management (in millions)		5,826		2,400		N/A		N/A		N/A
Present value of future cash flows (after tax) (d)		89,650		41,712		14,873		21,094		N/A
Statutory Financial Data (ACA Financial Guaranty)(e):
Contingency reserve (f)	$	31,520	$	21,162	$	13,959	$	7,903	$	2,985
Policyholders' surplus		137,783		123,635		106,802		76,054		77,834

(a)

(b)	Book value per share is based on total shareholders' equity divided by basic common shares outstanding including the assumed conversion of convertible preference shares and senior convertible preferred shares.

(c)	This information is not derived from our audited consolidated financial statements.

(d)

Includes the present value of installment premiums and future cash flows from CDOs discounted at 6% in 2003, 8% in 2002 and 6% in 2001 and 2000 net of taxes. Actual results will differ if the assumptions above prove incorrect. Management believes that this data provides more complete information regarding our potential future revenues. In particular, installment premiums are not reflected in unearned premiums but the present value of installment premiums is considered an important measure of future revenues for public financial guaranty insurance companies.

(e)	Derived from the statutory financial statements of ACA Financial Guaranty, which have been prepared in accordance with statutory accounting practices prescribed and permitted by the Maryland Insurance Administration, which differ in material respects from U.S. GAAP.

(f)

Under statutory accounting principles, we are required to establish contingency reserves based on a specified percentage of either written premiums or insured exposure by bond type. A contingency reserve is an additonal liability reserve established to protect the policyholder against the effects of adverse economic developments or cycles or other unforseen circumstances.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

Overview

The following discussion and analysis of our financial condition and results of operations should be considered along with a careful analysis of our consolidated financial statements and related notes included elsewhere in this prospectus. Some of the information contained in this discussion and analysis or in other sections of this prospectus may include forward-looking statements especially as they relate to our plans and strategy for our business. Forward-looking statements entail uncertainties and risks. Please see the "Forward-Looking Statements and Projections" for more information. You should also review the "Risk Factors" set forth elsewhere in this prospectus for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained herein.

Executive Summary

We provide financial guaranty and other insurance products and related financial services. We provide financial guaranty insurance primarily in connection with our credit enhancement of underserved segments of the municipal finance market. We originate, structure, credit enhance and provide asset management services for collateralized debt obligations as an alternative to the credit enhancement of individual corporate credits and asset-backed securities. In addition, we develop customized insurance products that typically address the regulatory, accounting and capital requirements of financial institutions.

We began operations in September 1997 as an "A" rated financial guarantor. Late in 2000, in response to ratings pressure and a deteriorating capital position, our board of directors hired new senior management and undertook a process to raise additional capital and to revise and expand our business model. Under the direction of the new management team, the focus of the municipal finance business was redirected from volume and revenue targets to transactional profitability. In addition, in our structured finance business, we discontinued the insurance of most third-party transactions and instead began originating proprietary CDOs. This was done to increase our control of risk and to create improved economics by capturing multiple fee-based and risk-based revenue sources. The implementation of the expanded business model also involved a corporate reorganization that included the termination of approximately one-half of the staff and the closure of two satellite offices.

We conduct our business through two operating segments:

•

Insurance, primarily financial guaranty insurance, which provides protection against payment defaults on municipal and non-municipal financial obligations. Our non-municipal insurance supports our customized solutions business, which includes credit enhancement of super-senior tranches of CDOs, certain capital relief products and structured participation in the insurance market. Also, our non-municipal insurance supports our financial services business by facilitating our ability to borrow funds to participate in the equity or "first loss" positions of our proprietary CDOs.


	Our insurance business is driven by several economic and industry specific factors that include: (i) interest rates, (ii) the financing needs of municipal issuers, (iii) the capital requirements of financial institutions, and (iv) the demand for "A" rated insurance. All of these impact the volume of available business and the profitability to us of such business.


•	Financial services, which includes our non-insurance participation in our CDO business. We originate, structure and provide asset management services for our proprietary CDOs.

Our proprietary CDO business is driven by several economic and industry specific factors that include: (i) the relationship between asset and liability yields, (ii) the availability and desirability of asset-backed securities, and (iii) the demand for CDO securities. All of these impact our ability to acquire sufficient assets to originate our proprietary CDOs consistent with our profitability targets.

For financial reporting purposes, and to reconcile to the totals reported in our consolidated financial statements, we have two additional segments which are not part of our operating segments, which we refer to as consolidated variable interest entities, or VIEs, and corporate/other.

•

Consolidated VIEs. Under FASB Interpretation No. 46, "Consolidation of Variable Interest Entities", or FIN 46, and prior accounting literature, we are required to consolidate VIEs when we are the primary beneficiary, defined as the entity maintaining the majority of the risks and rewards of ownership. The consolidated VIE segment includes revenue in the form of investment and derivative income on our consolidated CDOs. It also includes interest expenses associated with the liability payments on these CDOs. The consolidated VIE segment's revenues and expenses should net to zero unless there are timing differences. Timing differences include any temporary unrealized and realized gains and losses which are reflected in the consolidated VIE segment. We believe these will return to zero over time.


•	The corporate/other segment consists of revenue and expense items relating to corporate and other central costs not attributable to any individual segment. These items include unallocated investment income, overhead, depreciation and taxes.

Revenues

Within our insurance segment, our sources of revenue include:


(i)	Insurance premiums


•	Municipal financial guaranty – insuring the obligations of municipalities and other tax-exempt entities


•	Non-municipal financial guaranty – including insuring corporate obligations in CDOs, credit enhancement of "super-senior" tranches of CDOs, providing capital relief to financial institutions in our customized solutions business, and insuring the borrowings used to fund the equity or first loss position in our proprietary CDOs in our structured finance business


(ii)	Investment income – on fixed-income securities in our insurance company investment portfolio

Within our financial services segment, our sources of revenue include:


(i)	Fees


•	Warehousing fees – earned for the management of CDO assets during warehousing


•	Asset management fees – management of the CDO assets


•	Other fees – primarily CDO structuring and placement fees


(ii)	Derivative income – on credit default swaps in certain CDOs

Fees paid by consolidated VIEs are eliminated in consolidation. In addition to the revenue items listed above which are recurring and more predictable, we experience net realized and unrealized gains and losses on investments and net realized and unrealized gains and losses on derivatives. The gains and losses related to investments include both the gains and losses from our insurance company investment portfolio as well as gains and losses on assets from our consolidated CDOs. Net realized gains and losses result from the sale of securities executed as part of the ongoing management of our insurance company investment portfolio and of our proprietary CDOs. Our economic exposure to realized losses in our CDOs is limited to our participation in the equity tranches of the CDO. Under GAAP, we may realize losses in excess of our investment in the equity tranches of our CDOs, although we will recover those losses in excess of the equity on the termination of the CDO. See "Business—Financial Services." Net unrealized gains and losses relate to fluctuations based on changes in interest rates and credit quality.

Net realized and unrealized gains and losses on derivatives are a function of changes in the estimated fair value of the credit derivative contracts related to our proprietary CDO business in the

form of equity exposure to credit default swap CDOs, forward purchase agreements on warehoused assets and the credit enhancement of super-senior tranches of CDOs. We expect these unrealized gains and losses to fluctuate primarily based on changes in credit spreads and credit quality of the referenced entities (for the synthetic CDOs). We generally hold these derivative contracts to maturity and, in these cases, the cumulative unrealized gains and losses will net to zero if we incur no losses on that contract. Realized gains and losses can relate to a derivative security or forward purchase agreements on our proprietary CDO warehouse facilities. Gains or losses recorded during the warehousing period are recovered through amortization of the purchase premium or discount over the life of the applicable security purchased. For example, if, during the warehouse period the value of a security with a maturity of five years declined by $0.5 million, we would record an unrealized mark-to-market loss of $0.5 million in the "net realized and unrealized gains and losses on derivative instruments" line on the consolidated statement of income. When this security is purchased by the VIE under the forward purchase agreement, the purchase price is reduced by the $0.5 million. If this security is held to maturity (which is the expectation when purchased by the VIE), $0.1 million will be accreted into net investment income each year over the next five years, recovering the $0.5 million loss originally recorded in "net realized and unrealized gains and losses on derivative instruments" on the income statement.

Expenses

Our consolidated expenses include five types:


(i)	The provision for losses and loss adjustment expenses, or LAE, is a function of the amount and types of insurance business we write. Losses and LAE are based upon the ultimate aggregate losses expected to develop in our insurance portfolio. Typically these are calculated as a percentage of insurance premiums earned based on company and industry experience.


(ii)	Policy acquisition costs relate to the expenses incurred to generate insurance premiums, including, but not limited to, employee compensation expenses and premium taxes.


(iii)	Other operating expenses consist primarily of employee compensation and general operating expenses, including rent, marketing and advertising and other service fees.


(iv)	Interest expenses consist primarily of interest payments due on the debt of the consolidated VIEs as well as, to a lesser extent, the amortization of debt issuance costs (including rating, legal and banking fees related to our proprietary CDOs). Additionally, a portion of our interest expense is associated with various trust preferred debt we have issued.


(v)	Depreciation and amortization expenses primarily consist of the depreciation of office equipment.

Critical Accounting Policies

Our consolidated financial statements include amounts that, either by their nature or due to the requirements under U.S. GAAP, are determined using estimates and assumptions. The actual amounts ultimately realized could be materially different from the amounts provided in our consolidated financial statements. We believe the items and circumstances requiring the most subjective determinations are:


•	consolidation of VIEs


•	reserves for losses and LAE


•	valuation of derivatives


•	other than temporary impairments


•	deferred policy acquisition costs, or DPAC


•	premium revenue recognition


•	valuation of investments

An understanding of our accounting policies for these items is critically important to understanding our consolidated financial statements. The following discussion provides more information regarding the estimates and assumptions used for these items and should be read in conjunction with the notes to our consolidated financial statements.

Consolidation of VIEs

Under FIN 46, we must determine who is the primary beneficiary of our proprietary CDOs. Since we retain the equity interest, or first loss position, in certain of our proprietary CDOs, we are entitled to the majority of our proprietary CDOs' expected residual returns and losses. Thus, we have determined that under FIN 46 and previous accounting literature we are the primary beneficiary of our proprietary CDOs and must consolidate those CDOs subject to FIN 46 as VIEs. For example, in May 2003 we originated a proprietary CDO to which the provisions of FIN 46 had been applied. This CDO consists of an approximately $400 million portfolio of investment grade asset-backed securities and issued approximately $382 million of debt security tranches on top of $18 million of equity interest, which we retained. While we consolidate the VIE in accordance with FIN 46, our only risk relates to our $18 million equity investment. We do not have the right to use the assets of the CDO, and the $382 million of debt liabilities of the CDO are without recourse to us.

Because of the requirement to consolidate VIEs where we are the primary beneficiary, we may experience increased volatility on our financial statements which make their evaluation more difficult. Our contractual exposure to our CDO is limited to our equity interest. We record fluctuations in the value of the consolidated assets and liabilities of our CDOs. These fluctuations have exceeded our exposure in the past and could exceed our exposure in the future. This volatility could be recorded in our consolidated income statement as a realized loss, or in our consolidated accumulated other comprehensive income on the consolidated balance sheet in the form of unrealized gains and losses.

Reserves for Losses and Loss Adjustment Expenses

Reserves for losses and LAE are based upon estimates of the ultimate aggregate losses expected to develop in our insurance portfolio. The reserve for losses and LAE consists of unallocated loss reserves and case basis reserves. Case basis reserves are established for losses on identified guaranteed obligations that have already defaulted or are expected to default. These reserves are established in an amount that is sufficient to cover both the present value of the anticipated defaulted debt service payments over the expected period of default, plus the estimated expenses associated with settling claims, less the estimated recoveries under collateral and subrogation rights. We discount these reserves in accordance with discount rates prescribed by state regulatory authorities.

We establish and accrue an unallocated loss reserve, which is separate from case basis reserves. The unallocated loss reserve is established based upon the expected debt service defaults in the insured portfolio. Active surveillance of the insured portfolio enables us to track the credit migration of insured obligations from period to period. Senior management meets at least quarterly with our surveillance group to review the status of our credit portfolio. During these reviews, senior management determines the adequacy of our loss reserves based on the surveillance group reports, the latest available industry data, an analysis of historical default and recovery experience for the relevant sectors of the fixed-income market, and the changing mix of our book of business. A determination is then made as to any necessary adjustments to reserves.

Due to the inherent uncertainties of estimating loss and LAE reserves, actual experience may be materially different from the estimates reflected in our consolidated financial statements.

Valuation of Derivatives

In 2001, we adopted FAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", or FAS 133, which established accounting and reporting standards for derivative instruments and was subsequently amended. FAS 133 requires the recognition of derivative financial instruments, including embedded derivative instruments, as either assets or liabilities on the balance sheet and the measurement of those instruments at fair value.

We are required to recognize derivative activity when:


(i)	We originate credit default swap CDOs where we insure the equity or first loss position.


(ii)	We insure super-senior tranches of credit default swap CDOs


(iii)	We hedge against interest rate risk in our CDOs and


(iv)	We enter into forward purchase agreements to acquire asset-backed securities for our CDOs during the warehousing period.

(i)(ii) We view both (i) and (ii) above as an extension of our financial guaranty insurance business. However, under FAS 133 neither of these insurance contracts qualifies for the financial guaranty insurance scope exemption. As a result, in both instances our insurance contract is accounted for as a derivative and reported at fair value. Changes in fair value are included in our consolidated income statement as realized and unrealized gains and losses on derivative financial instruments. Since the equity tranche that we retain in our proprietary CDOs is not an actively traded security and has no observable market price and since our super-senior participation is highly structured, we utilize comprehensive internally developed models to estimate changes in fair value. We generally hold derivative contracts to maturity. Where we hold a derivative to maturity, and assuming no deterioration in credit quality, the cumulative unrealized gains and losses will offset each other over time.

(iii) We purchase interest rate swaps in our asset-backed CDOs to hedge the liabilities issued by the CDO vehicle. Our consolidated CDOs have floating-rate liabilities that serve to fund the purchase of fixed and floating rate assets. In order to minimize exposure to interest rate movement, we enter into interest rate swap contracts that match the fixed-rate assets with the floating-rate liabilities. The value of the swap will vary with changes in interest rates. Any ineffective portion of the cash flow hedge will have its change in fair value recorded in our consolidated income statement. The effective portion of a cash flow hedge is reflected in accumulated other comprehensive income.

(iv) We enter into forward purchase agreements on warehouse facilities through which we accumulate asset-backed securities for potential CDO transaction. The forward purchase agreement is a legal agreement to purchase the warehoused assets at their original cost from an investment bank, plus the cost of any interest rate hedges on the fixed-rate securities. We structure the agreement this way to lock in the credit price of the assets since the price is fixed and the interest rate risk is economically hedged. We enter into these agreements to insure that assets selected will ultimately be delivered with the desired credit spread to meet the return objectives of the CDO. For CDOs originated in 2003 and prior, these forward purchase agreements did not qualify for cash flow hedge accounting treatment under the contemporaneous documentation and aggregation of dissimilar assets requirements of FAS 133. Therefore, the changes in fair value of the forward purchase agreements were recorded in our consolidated income statement. Management believes that the forward purchase agreements entered into in 2002 and 2003 were economically effective in their purpose of locking in credit spreads. No assets purchased under these forward purchase agreements defaulted or have been considered to be other-than-temporarily impaired during the warehousing period. Valuation changes recorded under the forward purchase agreement were expected given the movement in credit spreads. Going forward, all forward purchase agreements will initially be structured and documented to qualify for cash flow hedge accounting treatment. Under cash flow hedge accounting, the effective portion of the valuation changes of the forward purchase derivative will be reflected in accumulated other comprehensive income on the balance sheet, subject to an impairment test.

Derivatives described in (iii) above qualify as cash flow hedges under FAS 133. The change in fair value of these cash flow hedges is included in other comprehensive income on our consolidated balance sheet.

We value derivative contracts based on quoted market prices, when available. However, if quoted prices are not available, the fair value is estimated using valuation models specific to the type of credit protection. Valuation models include the use of management estimates and current market information. Management is also required to make assumptions on how the fair value of derivative

instruments is affected by current market conditions. We utilize both proprietary and vendor based models (including rating agency models) and a variety of market data to provide the best estimate of fair value. Some of the more significant types of market data that influence our models include, but are not limited to, credit ratings, interest rates, credit spreads, default probabilities, and recovery rates. If management's underlying assumptions for evaluating fair value prove to be inaccurate, there could be material differences in our consolidated operating results.

Other Than Temporary Impairments

We have a formal review process for all securities in our investment portfolio, including a review for impairments. The following factors are considered when assessing impairment:


•	the level and duration of a decline in the fair value of a security;


•	a decline in the fair value of a security for a continuous period of 12 months;


•	recent credit downgrades of the applicable security or the issuer by rating agencies;


•	the current or forecasted financial condition of the applicable issuer;


•	interest payments;


•	the position of the security in the issuer's capital structure;


•	the length of time to maturity;


•	an estimate of expected cash flows for asset-backed securities;


•	interest rates; and


•	our intent and ability to hold the security until the fair value recovers.

If we believe that a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss on our balance sheet under "accumulated other comprehensive income," net of deferred income taxes, in shareholder's equity. If we believe the decline is "other than temporary," we write down the carrying value of the investment and record a realized loss in our income statement.

Other than temporary declines in the fair value of securities in our investment portfolio for the year ended December 31, 2003 was $0.8 million. There were no other than temporary declines for the years ended December 31, 2002 or 2001.

With respect to securities where the decline in value is determined to be temporary and the security's value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, taking into account changing information, market conditions and assessing value relative to other comparable securities. We believe that subsequent decisions to sell such securities are consistent with the classification of our portfolio as available for sale.

Certain of our CDOs are invested in subordinated classes (below "AA" ratings categories) of asset-backed securities. These assets are accounted for in accordance with Emerging Issues Task Force Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interest in Securitized Financial Assets". This statement addresses how a holder of a securitized financial asset should account for interest income and impairment. With respect to impairment losses, it requires that such losses be recognized if both of the following conditions are satisfied:


•	the fair value of the security is less than the security's carrying value, and


•	the most recent evaluation determines that there has been an adverse change in the cash flows.

We evaluate the cash flow of each security on a monthly basis to assess whether any impairments have occurred.

There are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include subsequent significant changes in general economic conditions as well as specific business conditions affecting particular issuers, assessment of issue-specific factors (e.g. seniority of claims, collateral value, collateral default rates, severity rates on defaulted collateral and prepayment speeds), future financial market effects, stability of foreign governments and economies, future rating agency actions and significant disclosure, accounting, fraud or corporate governance issues that may adversely affect certain investments. If management determines that a decline in fair value is temporary and hence a security's value is not written down at that time, there are potential effects upon our future earnings and financial position should management later conclude that some of the current declines in the fair value of the investments are other than temporary declines.

Deferred Policy Acquisition Costs

Within our insurance segment, we defer acquisition costs that are related to the acquisition of policies and premium production. Such costs are comprised primarily of premium taxes, personnel-related expenses of individuals involved in marketing, underwriting, and reinsurance functions, along with certain rating agency and legal fees. These costs are reduced by commissions from reinsurance to derive net acquisition costs. Net acquisition costs are deferred and amortized over the period in which the related premiums are earned. Anticipated claims and claim adjustment expenses are considered in determining the recoverability of acquisition costs. When an insured issue is retired early or is called by the issuer, remaining deferred acquisition costs relating to the policy are recorded in our consolidated statements of income.

Management uses its best judgment in determining what costs should be deferred, as well as what percentage of these costs should be deferred. We periodically conduct studies to determine which operating costs vary with, and are directly related to, the acquisition of new business and therefore qualify for deferral.

Premium Revenue Recognition

Premiums are generally received in advance or in installments. Premiums received in advance are non-refundable and are earned in proportion to the expiration of the related risk. Most of the obligations we insure have amortization or sinking fund provisions. Installment premiums are earned over each installment period, generally one year or less. Therefore, premium earnings are greater in the earlier periods of an upfront transaction when there is a higher amount of risk outstanding. The premiums are apportioned in accordance with the principal amortization schedule of the related bond issue and are earned ratably over the amortization period. When an insured issue is retired early or is called by the issuer, any remaining deferred premium revenue is recognized at that time. Accordingly, deferred premium revenue represents the portion of premiums written that is attributable to the unexpired risk of insured bonds or notes.

Valuation of Investments

Our investments are mainly comprised of fixed-income investments. These fixed income investments include the investments of our insurance company assets and the assets related to our consolidated VIEs and are carried on our balance sheet at fair market value. Quoted market prices are generally available for these investments. If a market price is not available, a price is derived from available market data and/or internal analysis. In certain cases where a particular security is not traded and we believe that available price quotes are not indicative of fair market value, fair value is determined by using internally developed discounted cash flow models using available market data and internal estimates. We had six such investments at December 31, 2003. If these non-market price assessments prove to be incorrect there may be a material effect on our balance sheet.

Results of Operations

The following is a discussion and analysis of our consolidated results of operations for the years ended December 31, 2003, 2002 and 2001.

Years ended December 31, 2003 and December 31, 2002

Gross Premiums Written. Gross premiums written for the year ended December 31, 2003 were $66.0 million compared with $55.3 million for the year ended December 31, 2002, an increase of $10.7 million. The increase was primarily related to an increase in municipal insurance gross premiums written of $3.5 million and an increase in non-municipal gross premiums written of $7.2 million. We believe that the growth in our municipal business has been driven by increased market acceptability of our insurance products in our selected markets, which resulted in an increase in our gross par written for municipal insurance. Gross par written for municipal insurance for the year ended December 31, 2003 was $1,082.5 million compared with $875.6 million for the year ended December 31, 2002. The increase in our non-municipal insurance was primarily due to increased market acceptance of our customized products and the annual installment premiums from business written in prior years resulting in a $7.0 million increase in gross premiums written.


	For the year ended December 31,
	2003		2002
	($ in millions)
Gross premiums written
Municipal	$	49.1	$	45.6
Non-municipal
Customized solutions		14.8		7.8
Structured finance		2.1		1.9
Total	$	66.0	$	55.3
Gross par written (municipal)	$	1,082.5	$	875.6

Net Premiums Written. Net premiums written for the year ended December 31, 2003 were $62.5 million compared with $47.4 million for the year ended December 31, 2002, an increase of $15.1 million. The difference between gross and net premiums written is the amount of premiums ceded during the period. We cede premiums under various contractual arrangements with third parties on a first loss or excess of loss basis, which are designed to provide protection against unexpected levels of losses. In addition, we cede premiums on a quota share basis when our insured exposure to any single credit exceeds the amount allowed by internal policies, the rating agencies and regulators. For the year ended December 31, 2003, we ceded $3.5 million and for the year ended December 31, 2002, we ceded $7.8 million.


	For the year ended December 31,
	2003		2002
	($ in millions)
Net premiums written
Municipal	$	46.1	$	38.1
Non-municipal
Customized solutions		14.3		7.4
Structured finance		2.1		1.9
Total	$	62.5	$	47.4

Premiums Earned. Premiums earned for the year ended December 31, 2003 were $23.9 million compared with $14.0 million for the year ended December 31, 2002, an increase of $9.9 million. Municipal premiums earned increased $3.6 million due to the increase in recognition of premiums written in prior periods and lower reinsurance cessions for the year ended December 31, 2003. Non-municipal premiums earned, primarily those related to our customized solutions business, increased $6.3 million due to increased premiums in our super-senior business, which are written and earned in the same period.


	For the year ended December 31,
	2003		2002
	($ in millions)
Premiums earned
Municipal	$	9.2	$	5.6
Non-municipal
Customized solutions		12.6		6.5
Structured finance		2.1		1.9
Total	$	23.9	$	14.0

Net Investment Income. Net investment income for the year ended December 31, 2003 was $52.9 million compared with $20.3 million for the year ended December 31, 2002, an increase of $32.6 million. This increase was primarily due to the closing of three proprietary CDOs in 2003 that we consolidated. We earned $42.7 million of investment income for the year ended December 31, 2003 on $2,834 million of consolidated CDO assets at December 31, 2003. This compares with $9.8 million of investment income for the year ended December 31, 2002 on $505.2 million of consolidated CDO assets at December 31, 2002. Our CDOs typically have an average life of five to seven years. As we originate and consolidate new CDOs, our investment income is likely to continue to increase until our CDOs begin to mature in proportion to our origination of new CDOs. We expect our first CDO to mature between 2007 and 2009. We expect to continue originating proprietary CDOs over the next several years. The balance of our net investment income, $11.6 million in 2003 and $11.0 million in 2002, consisted of interest on cash equivalents and fixed-income securities primarily in our insurance company investment portfolio. This increase was primarily the result of the increase in invested assets of $54.3 million. The weighted average book yield on our insurance company investment portfolio increased to 4.4% from 4.2%. Net investment income is recorded net of investment management, accounting and custody fees of $1.4 million for the year ended December 31, 2003 and $0.5 million for the year ended December 31, 2002.


	For the year ended December 31,
	2003			2002
	($ in millions)
Investment income – non-VIE	$	11.6		$	11.0
Investment income – VIE		42.7			9.8
Total investment income		54.3			20.8
Investment expenses		(1.4	)		(0.5	)
Net investment income	$	52.9		$	20.3

Net Realized Gains (Losses). Net realized gains for the year ended December 31, 2003 were $3.2 million compared with $4.1 million for the year ended December 31, 2002, a decrease of $0.9 million. Our net realized gains for the year ended December 31, 2003 were the result of net capital gains on our insurance company investment portfolio of $4.7 million, offset by losses of $1.5 million relating to our consolidated CDOs. $0.7 million of the loss was a result of the sale of one asset-backed security held in one of our consolidated CDOs. We sold this asset-backed security in order to protect our equity position and to preserve the overall credit quality of the CDO. The remainder, a loss of $0.8 million, was a result of an other than temporary impairment on an asset-backed security also held in one of our consolidated CDOs. The gains from our insurance company investment portfolio are attributable to our modified total return investment management strategy and gains on our portfolio created by falling interest rates.

Net Realized and Unrealized Gains (Losses) on Derivative Instruments. Net realized and unrealized gains (losses) on derivative instruments for the year ended December 31, 2003 were a gain of $6.8 million compared to a loss of $8.7 million for the year ended December 31, 2002, an increase of $15.5 million. Net gains on derivative instruments consisted of an unrealized gain of $9.9 million

and a realized loss of $3.1 million for the year ended December 31, 2003. For the year ended December 31, 2002, net losses on derivative instruments consisted of an unrealized loss of $2.8 million and a realized loss of $5.9 million. These gains and losses are primarily related to our forward purchase agreements to purchase warehoused assets for pending CDOs at their original cost, plus the cost of any interest rate hedges on the fixed rate securities. The realized loss represents the transfer or termination costs of the interest rate swaps on the fixed rate assets in the warehouse facilities. The realized losses that relate to swap termination payments are affected by interest rates. During the warehousing of our CDOs in 2003, rates declined less than in 2002, resulting in a smaller loss for the year ended December 31, 2003. Also, for the year ended December 31, 2003, $2.0 million of the unrealized gains were the result of unrealized mark-to-market gains on derivatives underlying our super-senior business.

Derivative Income. Derivative income for the year ended December 31, 2003 was $12.0 million compared with $5.0 million for the year ended December 31, 2002, an increase of $7.0 million. This increase was primarily the result of increased derivative income on a consolidated credit default swap CDO of $4.5 million and increased derivative income of $1.1 million on a credit derivative contract relating to a portfolio of high-quality corporate credit risk.

Fee Income. Fee income for the year ended December 31, 2003 was $8.9 million compared with $4.2 million for the year ended December 31, 2002, an increase of $4.7 million. This increase was primarily the result of increased warehouse fees related to the formation of three consolidated CDOs and asset management fees from two non-consolidated CDOs. Fee income also includes revenues from certain municipal transactions in the secondary markets and related structuring fees.


	For the year ended December 31,
	2003		2002
	($ in millions)
Fee income
Warehousing fees	$	4.6	$	1.8
Asset management fees		2.5		1.4
Other		1.8		1.0
Total	$	8.9	$	4.2

Provision for Losses and Loss Adjustment Expense. Provision for losses and LAE for the year ended December 31, 2003 was $3.2 million compared with $1.8 million for the year ended December 31, 2002, an increase of $1.4 million. This was a direct result of the increase in premiums earned, and represents management's estimate of losses on our insured book of business. For a detailed description of how we establish our reserve for losses and LAE see "—Critical Accounting Policies" above.

Net Policy Acquisition Costs. Policy acquisition costs for the year ended December 31, 2003 were $4.1 million compared with $4.0 million for the year ended December 31, 2002, an increase of $0.1 million. This increase was consistent with the increase in premiums earned and the amortization of deferred expenses.

Other Operating Expenses. Other operating expenses for the year ended December 31, 2003 were $29.5 million compared with $18.7 million for the year ended December 31, 2002, an increase of $10.8 million. This change was driven by $1.3 million of additional CDO operating expenses, $3.6 million related to employee compensation and benefits expense, primarily driven by the addition of employees to our structured finance business throughout late 2002 and 2003. The remaining $5.9 million was attributable to general corporate overhead expenses.

Interest Expense. Interest expense for the year ended December 31, 2003 was $42.0 million compared with $9.9 million for the year ended December 31, 2002, an increase of $32.1 million. This increase was a result of increased debt issuance of $2,390.0 million related to our consolidated CDOs, resulting in increases in both interest expense and amortization of debt issuance costs. Interest expense also included the interest on $20.6 million, $20.6 million and $18.0 million of debt issued to

the trust preferred vehicle issued on October 29, 2003, May 15, 2003, and December 4, 2002, respectively.


	For the year ended December 31,
	2003		2002
	($ in millions)
Interest expense – Trust preferred debt	$	1.9	$	0.1
Interest expense – CDO debt		36.8		8.5
Other interest expense		0.2		0.4
Amortization of debt issuance costs		3.1		0.9
Total interest expense	$	42.0	$	9.9

Depreciation and Amortization. Depreciation and amortization expenses for the year ended December 31, 2003 were $1.3 million compared with $1.1 million for the year ended December 31, 2002, an increase of $0.2 million. This $0.2 million increase was mainly the result of increased costs related to fixed assets.

Provision for Income Taxes. Provision for income taxes for the year ended December 31, 2003 was $10.7 million compared with an income tax benefit of $0.4 million for the year ended December 31, 2002, resulting in an effective tax rate of 38.4% and a negative 10.8%, respectively. The significant change in the effective tax rate resulted from the release of the valuation allowance in the fourth quarter of 2002.

Net Income (Loss). Net income for the year ended December 31, 2003 was $17.2 million compared with $4.6 million for the year ended December 31, 2002, an increase of $12.6 million.

Years ended December 31, 2002 and December 31, 2001

Gross Premiums Written. Gross premiums written for the year ended December 31, 2002 were $55.3 million compared with $23.0 million for the year ended December 31, 2001, an increase of $32.3 million. The increase was primarily related to an increase in our municipal insurance gross premiums written of $28.6 million. In addition, our non-municipal insurance gross premiums increased $3.7 million. Gross par written for municipal insurance for the year ended December 31, 2002 was $875.6 million compared with $365.6 million written for the year ended December 31, 2001. The increase was primarily due to our being removed from credit watch early in 2001 that adversely impacted 2001 business written.


	For the year ended December 31,
	2002		2001
	($ in millions)
Gross premiums written
Municipal	$	45.6	$	17.0
Non-municipal
Customized solutions		7.8		6.0
Structured finance		1.9		—
Total	$	55.3	$	23.0
Gross par written (municipal)	$	875.6	$	365.6

Net Premiums Written. Net premiums written for the year ended December 31, 2002 were $47.4 million compared with $5.5 million for the year ended December 31, 2001, an increase of $41.9 million. In the year ended December 31, 2002, we ceded $7.8 million of which $6.9 million under various contractual arrangements with third parties on a first loss or excess of loss basis designed to provide protection against unexpected levels of losses. In the year ended December 31, 2001, we ceded $17.6 million of which $10.2 million was ceded on a first loss or excess of loss basis and the remainder was ceded to assure compliance with insurance regulatory single risk limits. The decline in cessions was primarily due to a $7.0 million non-recurring "first-loss" reinsurance cession in 2001. In addition, we terminated a reinsurance treaty and replaced it with another reinsurance treaty at a lower

cost. For the period ended December 31, 2001 we had negative municipal premiums written due to ceding more business than we wrote. This was done by new management to create a "first loss" reinsurance facility to cover any unexpected losses that may have been embedded in the insured portfolio to that date.


	For the year ended December 31,
	2002		2001
	($ in millions)
Net premiums written
Municipal	$	38.1	$	(0.4	)
Non-municipal
Customized solutions		7.4		5.9
Structured finance		1.9		—
Total	$	47.4	$	5.5

Premiums Earned. Premiums earned for the year ended December 31, 2002 were $14.0 million compared with $6.7 million for the year ended December 31, 2001, an increase of $7.3 million. Municipal premiums earned increased $5.0 million due to the increase in recognition of premiums written in prior periods and lower reinsurance cessions for the year ended December 31, 2002. Non-municipal premiums earned, primarily those related to our structured finance business, increased $2.3 million due to the initiation of our proprietary CDO business.


	For the year ended December 31,
	2002		2001
	($ in millions)
Premiums earned
Municipal	$	5.6	$	0.6
Non-municipal
Customized solutions		6.5		6.1
Structured finance		1.9		—
Total	$	14.0	$	6.7

Net Investment Income. Net investment income for the year ended December 31, 2002 was $20.3 million compared with $11.6 million for the year ended December 31, 2001, an increase of $8.7 million. In 2001, we changed our approach to the structured finance market. We discontinued providing traditional credit enhancement to asset backed securities and began executing our strategy of participating in the structured finance market through our proprietary CDO business. During 2002 we closed our first two consolidated CDOs. This resulted in investment income in 2002 of $9.8 million earned on $505.2 million of consolidated CDO assets at December 31, 2002. For the year ended December 31, 2001 we had no consolidated VIEs. Our first CDO which required consolidation closed in June 2002. The balance of our net investment income, $11.0 million and $12.1 million for the years ended December 31, 2002 and 2001, respectively, consisted of interest on cash and fixed-income securities in our insurance company investment portfolio. This decrease was the result of lower interest rates. The weighted average book yield on our insurance company investment portfolio decreased to 4.2% from 5.0%. Net investment income was partially offset by expenses for investment management, accounting and custody fees of $0.5 million for each of the years ended December 31, 2002 and 2001.


	For the year ended December 31,
	2002			2001
	($ in millions)
Investment income – non-VIE	$	11.0		$	12.1
Investment income – VIE		9.8			—
Total investment income		20.8			12.1
Investment expenses		(0.5	)		(0.5	)
Net investment income	$	20.3		$	11.6

Net Realized Gains. Net realized gains for the year ended December 31, 2002 were $4.1 million compared with $6.5 million for the year ended December 31, 2001, a decrease of $2.4 million. Our net realized gains resulted from the sale of fixed income securities executed as part of the ongoing management of our insurance company investment portfolio.

Net Realized and Unrealized Gains (Losses) on Derivative Instruments. Net realized and unrealized loss on derivative instruments for the year ended December 31, 2002 was $8.7 million. We had no realized gains or losses on derivatives for the year ended December 31, 2001. Our first warehouse facility was in the early stages of asset accumulation in late 2001, with no changes in the fair values. The 2002 loss represents realized and unrealized losses on the assets being held in various warehouse facilities prior to those assets being purchased by a VIE that we consolidate under FIN 46. These gains and losses are related to our forward purchase agreements to purchase these warehoused assets for pending CDOs at their original cost, plus the cost of any interest rate hedges on the fixed rate securities. The net unrealized losses of $2.4 million and $0.4 million represent the change in value of the underlying assets being accumulated in the warehouse facilities and the non-consolidated CDS CDOs, respectively. The realized loss of $5.9 million represents the transfer or termination costs of the interest rate swaps on the fixed rate assets in the warehouse facilities. Net realized and unrealized gains and losses during the warehouse period do not impact our expectation of the economic benefits to us derived from a CDO transaction.

Derivative Income. Derivative income for the year ended December 31, 2002 was $5.0 million. This was the result of a consolidated credit default swap CDO which closed in the second quarter of 2002. We had no derivatives in 2001.

Fee Income. Fee income for the year ended December 31, 2002 was $4.2 million compared with $0.2 million for the year ended December 31, 2001, an increase of $4.0 million. This increase was primarily the result of increased warehouse fees related to the formation of one proprietary CDO and asset management fees from two non-consolidated CDOs. We closed our first credit default swap CDO on January 25, 2002 and our only fee income in 2001 was $0.2 million primarily from fees earned on municipal transactions in the secondary market.


	For the year ended December 31,
	2002		2001
	($ in millions)
Fee income
Warehouse fees	$	1.8	$	—
Asset management fees		1.4		—
Other		1.0		0.2
Total	$	4.2	$	0.2

Provision for Losses and Loss Adjustment Expenses. Provision for losses and LAE for the year ended December 31, 2002 was $1.8 million compared with $1.6 million for the year ended December 31, 2001, an increase of $0.2 million. This increase was a direct result of the increase in premiums earned in the year ended December 31, 2002. In addition, for the year ended December 31, 2001 there was included in the $1.6 million a provision for a loss of $0.9 million, as a result of a paid loss

on a municipal obligation. For a detailed description of how we establish our reserve for losses and LAE see "—Critical Accounting Policies" above.

Net Policy Acquisition Costs. Net policy acquisition costs for the year ended December 31, 2002 were $4.0 million compared with $3.7 million for the year ended December 31, 2001, an increase of $0.3 million. This increase was consistent with the increase in premiums earned and the resulting amortization of deferred expenses.

Other Operating Expenses. Other operating expenses for the year ended December 31, 2002 were $18.7 million compared with $14.3 million for the year ended December 31, 2001, an increase of $4.4 million. This increase was primarily driven by the continued compensation and operating expense growth related to our proprietary CDO and other structured finance products.

Interest Expense. Interest expense for the year ended December 31, 2002 was $9.9 million compared with $0.1 million for the year ended December 31, 2001, an increase of $9.8 million. This increase was a result of both increased debt issuance of $523.5 million related to our consolidated CDOs and the interest on $17.5 million of trust preferred debt issued on December 4, 2002. The following table sets forth the composition of our interest expense.


	For the years ended December 31,
	2002		2001
	($ in millions)
Interest expense – Trust preferred debt	$	0.1	$	—
Interest expense – CDO debt		8.5		—
Other interest expense		0.4		0.1
Amortization of debt issuance expenses		0.9		—
Total interest expense	$	9.9	$	0.1

Depreciation and Amortization. Depreciation and amortization expenses for the year ended December 31, 2002 were $1.1 million compared with $0.7 million for the year ended December 31, 2001, an increase of $0.4 million. This increase was primarily a result of increased amortization on leasehold improvements and depreciation on office equipment.

Reorganization Costs. Reorganization costs for the year ended December 31, 2001 were $1.7 million. This expense was related to a major reorganization, which included a termination of approximately one half of our staff and the closure of two satellite offices. There were no reorganization costs for the year ended December 31, 2002. See note 2 to the notes to our consolidated financial statements for further information.

Provision for Income Taxes. Provision for income taxes for the year ended December 31, 2002 was a benefit of $0.4 million compared with an expense of $0.1 million for the year ended December 31, 2001, resulting in an effective tax rate of negative 10.8% and 4.0%, respectively. Through 2001, a full valuation allowance was maintained against our gross deferred tax assets due to the uncertainty of the benefit of their realization. However, in the fourth quarter of 2002, as a result of our current and projected profitability, the valuation allowance was released which resulted in recognition of approximately a $2.4 million tax benefit. See Note 10 to the notes to our consolidated financial statements for further information.

Net Income (Loss). Net income for the year ended December 31, 2002 was $4.6 million compared with $2.6 million for the year ended December 31, 2001, an increase of $2.0 million.

Results by Operating Segments

We have two operating segments: (i) insurance, and (ii) financial services. For financial reporting purposes, two additional segments are reported: consolidated VIEs and corporate/other.

The following tables summarize the results for our business segments as of and for the years ended December 31, 2003, 2002 and 2001:


	December 31, 2003
	Insurance		Financial Services		Consolidated VIEs		Corporate/ Other			Segment Eliminations			Total Consolidated
	($ in millions)
Net premiums written	$	66.2	$	—	$	—	$	—		$	(3.7	)	$	62.5
Premiums earned		27.6		—		—		—			(3.8	)		23.8
Total revenues		44.5		19.1		56.9		0.4			(12.9	)		108.0
Total expenses		19.1		17.5		53.5		2.8			(12.8	)		80.1
Income (loss) before income taxes		25.4		1.6		3.4		(2.4	)		(0.1	)		27.9
Assets		431.8		12.1		2,985.6		38.9			—			3,468.5


	December 31, 2002
	Insurance		Financial Services			Consolidated VIEs			Corporate/ Other			Segment Eliminations			Total Consolidated
	($ in millions)
Net premiums written	$	49.6	$	—		$	—		$	—		$	(2.2	)	$	47.4
Premiums earned		15.7		—			—			—			(1.7	)		14.0
Total revenues		30.8		4.8			9.5			0.3			(5.8	)		39.6
Total expenses		16.2		9.9			14.7			0.8			(6.1	)		35.5
Income (loss) before income taxes		14.6		(5.1	)		(5.2	)		(0.5	)		0.3			4.1
Assets		349.4		15.8			536.0			14.8			—			917.0


	December 31, 2001
	Insurance		Financial Services			Consolidated VIEs		Corporate/ Other			Segment Eliminations		Total Consolidated
	($ in millions)
Net premiums written	$	5.5	$	—		$	—	$	—		$	—	$	5.5
Premiums earned		6.7		—			—		—			—		6.7
Total revenues		24.7		—			—		0.2			—		24.9
Total expenses		19.9		0.1			—		2.2			—		22.2
Income (loss) before income taxes		4.8		(0.1	)		—		(2.0	)		—		2.7
Assets		286.0		5.2			—		7.9			—		299.1

Insurance Operations

Our insurance segment includes financial guaranty insurance which provides protection against payment defaults on municipal bonds and structured finance obligations and supports our structured finance business by facilitating our ability to borrow funds to participate in the equity or first loss positions in our proprietary CDOs.


	Year Ended December 31,
	2003		2002
	($ in millions)
Net premiums written	$	66.2	$	49.6
Premiums earned		27.6		15.7
Net investment income (including realized gains and losses)		14.5		14.4
Net realized and unrealized gain on derivative instruments		2.0		—
Fee and other income		0.4		0.7
Total revenues		44.5		30.8
Total expenses		19.1		16.2
Income (loss) before income taxes	$	25.4	$	14.6

Years ended December 31, 2003 and December 31, 2002

Net Premiums Written. Net premiums written for the year ended December 31, 2003 were $66.2 million compared with $49.6 million for the year ended December 31, 2002, an increase of $16.6 million. This is due to both an increase of $8.0 million in municipal net premiums written and a $8.6 million increase in non-municipal insurance premiums which we believe is the result of the increased market acceptance of the ACA insurance product.

Premiums Earned. Premiums earned for the year ended December 31, 2003 were $27.6 million compared with $15.7 million for the year ended December 31, 2002, an increase of $11.9 million. The increase is attributable primarily to $14.7 million of non-municipal installment premiums earned in the year ended December 31, 2003, compared to $8.3 million of installment premiums earned from our non-municipal business in the year ended December 31, 2002. This is attributable to an increase in credit enhancement business related to our customized solutions business.

Net Investment Income (including realized gains and losses). Net investment income for the year ended December 31, 2003 was $14.5 million compared with $14.4 million for the year ended December 31, 2002, an increase of $0.1 million. This represents the investment income on our insurance company portfolio. This was primarily due to an increase in net realized gains of $0.6 million offset by a decrease in net investment income of $0.5 million due to lower prevailing interest rates.

Net realized and unrealized gain on derivative instruments. Net realized and unrealized gains on derivatives for the year ended December 31, 2003 was $2.0 million. This was the result of unrealized mark-to-market gains underlying our super-senior business and our insured unfunded synthetic CDS CDOs.

Expenses. Expenses for the year ended December 31, 2003 were $19.1 million compared with $16.2 million for the year ended December 31, 2002, an increase of $2.9 million, which is primarily attributable increases in employee compensation and other operating expenses.

Income (Loss) Before Income Taxes. Income before income taxes for the year ended
December 31, 2003 was $25.4 million compared with $14.6 million for the year ended December 31, 2002, an increase of $10.8 million.


	Years Ended December 31,
	2002		2001
	($ in millions)
Net premiums written	$	49.6	$	5.5
Premiums earned		15.7		6.7
Net investment income (including realized gains and losses)		14.4		17.9
Fee and other income		0.7		0.1
Total revenues		30.8		24.7
Total expenses		16.2		19.9
Income (loss) before income taxes	$	14.6	$	4.8

Years ended December 31, 2002 and December 31, 2001

Net Premiums Written. Net premiums written for the year ended December 31, 2002 were $49.6 million compared with $5.5 million for the year ended December 31, 2001, an increase of $44.1 million. The increase is due to a $38.5 million increase in municipal net premiums written and a $5.7 million increase in our non-municipal insurance, which we believe is the result of increased market acceptance of our insurance product following a corporate reorganization and an additional capital infusion in 2001.

Premiums Earned. Premiums earned for the year ended December 31, 2003 were $15.7 million compared with $6.7 million for the year ended December 31, 2002, an increase of $9.0 million. The increase is attributable to the recognition of municipal premiums received in prior periods and $8.3 million of non-municipal installment premiums earned in the year ended December 31, 2002, compared to $6.0 million of installment premiums earned from our non-municipal business for the year ended December 31, 2001. This is attributable to an increase in credit enhancement business related to our customized solutions business.

Net Investment Income (including realized gains and losses). Net investment income for the year ended December 31, 2002 was $14.4 million compared with $17.9 million for the year ended December 31, 2001, a decrease of $3.5 million. The decrease is related to a reduction in realized capital gains of $2.4 million for the year ended December 31, 2002.

Expenses. Expenses for the year ended December 31, 2002 were $16.2 million compared with $19.9 million for the year ended December 31, 2001, a decrease of $3.7 million. The decrease in expenses was primarily the result of expense controls initiated at the end of 2001 arising from a corporate reorganization.

Income (Loss) Before Income Taxes. Income before income taxes for the year ended December 31, 2002 was $14.6 million compared with $4.8 million for the year ended December 31, 2001, an increase of $9.8 million.

Financial Services

Our financial services segment includes origination, structuring, placement and asset management fees in our proprietary CDO business. In addition, it includes the excess distributions received on our equity or first loss position on two of our managed CDOs that do not involve VIEs and are not consolidated. The equity distributions from these CDOs are recognized as derivative income.


	Years Ended December 31,
	2003			2002
	($ in millions)
Investment income (loss)	$	(0.3	)	$	0.3
Net realized and unrealized gain (loss) on derivative instruments		1.4			(3.4	)
Derivative income		1.9			0.6
Fee and other income		16.0			7.3
Total revenues		19.0			4.8
Interest expense		1.1			1.8
Total expenses		17.5			9.9
Income (loss) before income taxes	$	1.5		$	(5.1	)

Years ended December 31, 2003 and December 31, 2002

Net Realized and Unrealized Gains (Loss) on Derivative Instruments. Net realized and unrealized gains for the year ended December 31, 2003 were $1.4 million compared with a loss of $3.4 million for the year ended December 31, 2002, an increase of $5.1 million. These gains represent the realized and unrealized gains on our forward purchase agreements which relates to balances on our outstanding warehouse assets.

Derivative income and fee and other income. Derivative income and fee and other income for the year ended December 31, 2003 was $17.9 million compared with $7.9 million for the year ended December 31, 2002, an increase of $10.0 million. This increase was primarily a result of a full year of revenue earned on three proprietary CDOs that closed in 2002 and the incremental revenue from four additional CDOs that closed in 2003. These revenues include: warehousing, structuring and asset management fees, and derivative income from credit default swap CDOs.

Expenses. Expenses for the year ended December 31, 2003 were $17.5 million compared with $9.9 million for the year ended December 31, 2002, an increase of $7.6 million. This increase was a result of our continued origination of proprietary CDOs and the related operating and compensation expenses as we expanded the segment's employee base. Expenses also included the interest expense on the borrowings used to fund the equity portion of our CDOs of $1.1 million and $1.8 million for the year ended December 31, 2003 and 2002, respectively.

Income (Loss) Before Income Taxes. Income before income taxes for the year ended December 31, 2003 was $1.6 million compared with a loss of $5.2 million for the year ended December 31, 2002, an increase of $7.0 million.


	Years Ended December 31,
	2002			2001
	($ in millions)
Investment income	$	0.3		$	—
Net realized and unrealized gain (loss) on derivative instruments		(3.4	)		—
Derivative income		0.6			—
Fee and other income		7.3			0.0
Total revenues		4.8			0.0
Interest expense		1.8			—
Total expenses		9.9			0.1
Income (loss) before income taxes	$	(5.1	)	$	(0.0	)

Years ended December 31, 2002 and December 31, 2001

Our financial services segment was operating for less than thirty days of the year ended December 31, 2001.

Net Realized and Unrealized Gains (Loss) on Derivative Instruments. Net realized and unrealized losses for the year ending December 31, 2002 were a loss of $3.4 million. These losses represent the unrealized fair value changes in our forward purchase agreements which relate to balances on outstanding warehouse assets.

Derivative income and fee and other income. Derivative income and fee and other income for the year ended December 31, 2002 was $7.9 million. Our revenue was a result of the initiation and growth of our proprietary CDO business and includes fee income from warehousing, structuring and asset management and derivative income related to our non-consolidated CDOs.

Expenses. Expenses for the year ending December 31, 2002 were $9.9 million. This increase was a result of the initiation and growth of our proprietary CDO business and the related operating and compensation expenses, as we expanded the segment's employee base. Expenses also included the interest expense on our funding notes of $1.8 million in 2002.

Income (Loss) Before Income Taxes. Loss before income taxes for the year ended December 31, 2002 was $5.1 million.

Consolidated VIEs

We consider our consolidated VIEs a separate segment only for financial reporting purposes and to reconcile to the totals reported in our consolidated financial statements. We do not consider it to be an operating segment. It is necessary to highlight the activity in this segment because it clarifies our consolidated financial statements. The consolidated VIE segment includes revenue in the form of investment and derivative income on our consolidated CDOs. It also includes interest expenses associated with the liability payments on these CDOs. In addition, any temporary unrealized and realized gains and losses would be reflected in the consolidated VIE segment as it is our belief that these will return to zero over time.

Liquidity and Capital Resources

We are a holding company, and as such, have no direct operations of our own. Our liquidity on a short-term basis (for the next twelve months), is largely dependent upon: (1) investment income from our invested assets and (2) external financings. On a long-term basis (beyond the next twelve months), we expect our liquidity to benefit from the previously mentioned factors as well as the ability of our subsidiaries to pay dividends or make other payments to ACA Holdings. Certain of our operating subsidiaries are subject to restrictions on their ability to pay dividends without the approval of the Maryland Insurance Commissioner until they have a positive earned surplus calculated on a SAP basis. See "Regulation." As of December 31, 2003 ACA Financial Guaranty was unable to pay dividends due to statutory insurance restrictions and will not be able to pay dividends until it earns more than $53.5 million on a SAP basis. Our non-insurance subsidiaries are not subject to regulatory restrictions with regard to dividend payments to the holding company. However, further liquidity requirements restrict their ability to pay dividends in the short term, during which time they will retain earnings to meet their operating needs.

In the ordinary course of our business, we evaluate our liquidity needs and capital resources in light of holding company expenses, debt-related expenses and rating agency capital requirements. ACA Holdings' liquidity requirements consist primarily of interest on our capital securities. We may also require liquidity to make periodic capital investments in our operating subsidiaries. It is our current policy to retain earnings to support the growth of our businesses and we do not currently intend to pay dividends. Based on the amount of income we expect to receive on our invested assets, we believe that ACA Holdings will have sufficient liquidity to satisfy its needs over the next twelve months. Beyond the next twelve months, a variety of factors, including market and general economic conditions that effect investment income on our invested assets and the ability of our subsidiaries to pay dividends, will affect the sufficiency of our liquidity. Consequently, although we believe that ACA Holdings will continue to have sufficient liquidity to meet its debt service and other obligations over the long term, we can not guarantee that we will not be required to seek external equity financing in order to meet our debt service obligations.

Liquidity at our operating subsidiaries is used to pay operating expenses, claims, obligations on our debt, reinsurance premiums, and where appropriate, to make capital investments in their own subsidiaries. In addition, certain of our operating companies may be required to post collateral in connection with credit derivatives and reinsurance transactions. Management believes that these subsidiaries' operating needs generally can be met from operating cash flow. For our insurance subsidiaries, this includes gross written premiums and investment income on their respective investment portfolios. The cash flow of certain of our non-insurance subsidiaries related to our CDO business is restricted by contract until we satisfy certain collateral or funding obligations related to the borrowings used to finance the equity of the CDOs we originate. This cash flow would be sufficient to meet the operating expenses of these subsidiaries if it were not restricted. We anticipate that these obligations will be satisfied on our existing CDOs beginning in 2006, and as a result this cash flow will no longer be restricted and will be available for dividends. To date, we have funded the operating expenses of these non-insurance subsidiaries through a combination of intercompany borrowings and from the proceeds of the trust preferred debt we have issued. We anticipate using a portion of the proceeds from this offering to fund the operations of certain non-insurance subsidiaries until cash generated by such non-insurance subsidiaries is no longer restricted.

On an ongoing basis, our sources of funds primarily consist of premiums written, investment income and proceeds from the sale and redemption of investments. Cash is used primarily to pay losses and loss expenses, policy acquisition costs, other operating expenses and interest expenses.

Our cash flow from operations generally represents the difference between premiums collected along with the investment income realized, and investment earnings realized and the losses and loss expenses paid, policy acquisition and other operating expenses and investment losses realized. Cash flow from operations may differ substantially from net income. To date, we have invested all cash flow that is not required for operating purposes.

If the rating agencies were to reduce ACA Financial Guaranty's financial strength rating to below "A", we would be severely limited in our ability to issue new insurance of municipal bonds. In addition, if that happened, we could be required to provide collateral in the form of cash or securities to back guaranties we have issued or in certain instances be replaced as the collateral manager in our managed CDOs. If these events occurred, it could materially hurt our financial performance and liquidity and severely strain our capital resources.

We expect that the proceeds of this offering will permit us to continue to implement our business strategy. We expect our existing capital base and the associated earnings, along with the proceeds of this offering, to be sufficient to operate our business. However, there can be no assurance that we will not need to raise additional capital in the future.

Cash Flows for the year ended December 31, 2003

In the year ended December 31, 2003, we generated positive net operating cash flow of $66.0 million, primarily related to premiums written and investment income. During the same period, we invested a net cash amount of $2.4 billion. We generated a net cash amount of $2.4 billion through financing activities, and as of December 31, 2003, had a cash balance of $212.5 million.

On October 29, 2003, we privately placed $20.0 million of trust preferred debt which was issued by a subsidiary trust holding $20.6 million aggregate principal amount of a thirty-year subordinated note of ACA Holdings. Net proceeds were $19.4 million. ACA Holdings provided a $10.0 million capital infusion to its direct subsidiary, ACA Financial Guaranty, and used the remainder of the net proceeds for general corporate purposes.

On May 15, 2003, we privately placed $20.0 million of trust preferred debt which was issued by a subsidiary trust holding $20.6 million aggregate principal amount of a thirty-year subordinated note of ACA Holdings. Net proceeds were $19.4 million. ACA Holdings provided a $10.0 million capital infusion to its direct subsidiary, ACA Financial Guaranty, and used the remainder of the net proceeds for general corporate purposes.

Cash Flows for the year ended December 31, 2002

In the year ended December 31, 2002, we generated a net operating cash inflow of $45.4 million, primarily relating to premiums received and investment income. During the same period, we invested

a net cash amount of $526.5 million. We generated a net cash amount of $531.1 million through financing activities, and as of December 31, 2002 had a cash and cash equivalents balance of $82.4 million.

On December 4, 2002, we privately placed $17.5 million of trust preferred debt which was issued by a subsidiary trust holding $18.0 million aggregate principal amount of a thirty-year subordinated note of ACA Holdings. Net proceeds were $17.0 million. ACA Holdings provided a $10.0 million capital infusion to its direct subsidiary, ACA Financial Guaranty and used the remainder of the net proceeds for general corporate purposes.

Cash Flows for the year ended December 31, 2001

In the year ended December 31, 2001, we generated a net operating cash inflow of $0.6 million, primarily relating to premiums received and investment income. During the same period, we invested a net cash amount of $24.4 million. We generated a net cash amount of $42.3 million through financing activities, and as of December 31, 2001 had a cash and cash equivalents balance of $32.4 million.

We did not make any significant capital expenditures during the year ended December 31, 2003 or the year ended December 31, 2002. We do not anticipate any significant capital expenditures for 2004.

The following table summarized our contractual obligations as of December 31, 2003.


	As of December 31, 2003
	Less Than One Year		1-3 Years		4-5 Years		After 5 Years		Total
	($ in millions)
Debt:
Non-VIE	$	—	$	—	$	16.0	$	143.5	$	159.5
VIE		1,265.7		—		107.1		1,432.0		2,804.8
Total long-term debt		1,265.7		—		123.1		1,575.5		2,964.3
Lease obligations		1.8		3.6		3.6		1.2		10.2
Total	$	1,267.5	$	3.6	$	126.7	$	1,576.7	$	2,974.5

Investment Portfolio

As of December 31, 2003, our investment portfolio consisted of $2,986.7 million of fixed maturity securities, of which $2,711.4 million were from VIEs that we consolidate under FIN 46, and $275.3 million were held in our insurance company investment portfolio. Our fixed maturity securities are designated as available for sale in accordance with FAS 115 "Accounting for Certain Investments in Debt and Equity Securities." Fixed maturity securities are reported at fair value in accordance with FAS 115, and the change in fair value is reported as part of accumulated other comprehensive income in shareholders' equity.

The following table summarizes our investment portfolio as of December 31, 2003:


	December 31, 2003
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Value
	($ in millions)
Available for sale (non-VIE)
U.S. Treasury securities	$	59.4	$	1.4	$	0.1	$	60.7
Federal agency securities		29.1		0.5		—		29.6
Obligations of states and political subdivisions		28.6		0.8		0.3		29.1
Corporate securities		58.8		0.4		0.6		58.6
Asset-backed securities		16.6		0.3		0.0		16.9
Mortgage-backed securities		80.3		0.5		0.4		80.4
Total non-VIE securities		272.8		3.9		1.4		275.3
Available for sale (VIE)
Asset-backed securities – VIE		2,700.2		20.7		9.5		2,711.4
Total	$	2,973.0	$	24.6	$	10.9	$	2,986.7

The amortized cost and estimated fair value of fixed maturity securities available for sale as of December 31, 2003, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. See Note 6 of the notes to our consolidated financial statements for information on our fixed maturity securities available for sale as of December 31, 2003 and 2002.


	December 31, 2003
	Amortized Cost		Estimated Fair Value
	($ in millions)
Available for sale:
Due in one year or less	$	18.2	$	18.3
Due after one year through five years		158.6		160.6
Due after five years through ten years		303.3		303.2
Due after ten years		2,492.9		2,504.6
Total	$	2,973.0	$	2,986.7

The amortized cost and estimated fair value of asset-backed securities owned by the VIEs at
December 31, 2003, included in the above chart by contractual maturity, are shown below:


	December 31, 2003
	Amortized Cost		Estimated Fair Value
	($ in millions)
Available for sale (VIE):
Due in one year or less	$	—	$	—
Due after one year through five years		77.6		77.6
Due after five years through ten years		262.8		262.6
Due after ten years		2,359.8		2,371.2
Total	$	2,700.2	$	2,711.4

Fair value of the fixed maturity securities is based upon quoted market prices provided by either independent pricing services or, when such prices are not available, by reference to broker or underwriter bid indications. For a detailed description of our valuation of investments, see "—Critical Accounting Policies" above.

We review our investment portfolio on at least a quarterly basis for possible impairment losses. For additional information, see "—Critical Accounting Policies" above.

The following table summarizes the ratings distributions of ACA Financial Guaranty's investment portfolio as of December 31, 2003, 2002 and 2001 and the investment portfolio of our consolidated VIEs as of December 31, 2003 and 2002:


	As of December 31,
	2003			2002			2001
AAA or Equivalent		36.4	%		29.5	%		62.8	%
AA		20.4	%		3.5	%		12.7	%
A		11.6	%		17.5	%		22.4	%
BBB		30.2	%		47.2	%		2.1	%
< BBB		1.4	%		2.3	%		0.0	%
Total		100.0	%		100.0	%		100.0	%

Ratings are represented by the lower of the S&P and Moody's Investors Service classifications.

The following table summarizes the unrealized losses in our investment portfolio by type of security and the length of time such securities have been in a continuous unrealized loss position as of December 31, 2003 ($ in thousands):


	As of December 31, 2003
	Estimated Fair Value		Gross Unrealized Losses
Non-VIE
U.S. Treasury & Federal agency securities
0 - 6 months	$	7,004	$	(12	)
7 - 12 months		6,002		(74	)
Greater than 12 months		—		—
		13,006		(86	)
Corporate securities
0 - 6 months	$	26,318	$	(369	)
7 - 12 months		—		—
Greater than 12 months		1,635		(234	)
		27,953		(603	)
Mortgage and asset-backed securities
0 - 6 months	$	35,842	$	(384	)
7 - 12 months		4,160		(12	)
Greater than 12 months		1,499		(33	)
		41,501		(429	)
Municipal securities
0 - 6 months	$	2,239	$	(19	)
7 - 12 months		14,405		(310	)
Greater than 12 months		—		—
		16,644		(329	)
Total non-VIE		99,104		(1,447	)
VIE: Asset-backed securities
0 - 6 months	$	422,910	$	(3,121	)
7 - 12 months		86,221		(3,546	)
Greater than 12 months		101,122		(2,831	)
Total VIE		610,253		(9,498	)
Total	$	709,357	$	(10,945	)

The following table summarizes the unrealized losses in our investment portfolio at December 31, 2003 by type of security and remaining time to maturity as of December 31, 2003 ($ in thousands):


	As of December 31, 2003
	Estimated Fair Value		Gross Unrealized Losses
Non-VIE
U.S. Treasury & Federal agency securities
due in one year or less	$	—	$	—
due after one year through five years		13,006		(86	)
due after five years through ten years		—		—
due after ten years		—		—
		13,006		(86	)
Corporate securities
due in one year or less	$	—	$	—
due after one year through five years		—		—
due after five years through ten years		14,994		(127	)
due after ten years		12,959		(476	)
		27,953		(603	)
Mortgage and asset-backed securities
due in one year or less	$	—	$	—
due after one year through five years		—		—
due after five years through ten years		—		—
due after ten years		41,501		(429	)
		41,501		(429	)
Municipal securities
due in one year or less	$	—	$	—
due after one year through five years		—		—
due after five years through ten years		4,440		(86	)
due after ten years		12,204		(243	)
		16,644		(329	)
Total non-VIE		99,104		(1,447	)
VIE
Asset-backed securities
Total VIE	$	610,253	$	(9,498	)
Total	$	709,357	$	(10,945	)

Market Risk

Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that impact the value of our financial instruments are interest rate risk, basis risk (for example, taxable interest rates relative to tax-exempt interest rates), and credit spread risk. Each of these risks and the specific types of financial instruments which they impact are described below. Senior managers in our risk management department are responsible for monitoring risk limits and applying risk measurement methodologies. The estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. We use various systems, models and stress test scenarios to monitor and manage market risk. These models include estimates made by management that use current and historic market information. The valuation results from these models could differ materially from amounts that actually are realized in the market. See "—Critical Accounting Policies—Valuation of Investments" and "—Valuation of Derivatives" above.


	December 31, 2003
	Notional Value of Derivatives		Estimated Fair Value			Hypothetical Fair Value After +100 Basis Point Parallel Yield Curve Shift			Hypothetical Change in Fair Value +100 Yield Shift			Hypothetical Fair Value After -100 Basis Point Parallel Yield Curve Shift			Hypothetical Change in Fair Value -100 Yield Shift
	($ in millions)
Financial assets with interest rate risk:
Fixed maturities:
Available for sale		—	$	2,986.7		$	2,953.8		$	(32.9	)	$	3,022.2		$	35.5

Derivatives:
Swaps		505.5		(45.9	)		(21.0	)		24.9			(72.4	)		(26.5	)
Options (interest rate caps)		161.3		2.6			4.1			1.5			1.4			(1.2	)

Total estimated potential (loss) gain									$	(6.5	)				$	7.8

Financial instruments that may be adversely affected by changes in interest rates consist primarily of investment securities. The primary objective in managing our investment portfolio is the generation of an optimal level of after-tax investment income while preserving capital and maintaining adequate liquidity. Investment strategies are based on many factors, including our tax position, fluctuations in interest rates, regulatory and rating agency criteria and other market factors. Two external investment managers, Stephens Capital Management Division, an affiliate of Stephens Group Inc. and Dreyfus Investment Advisors, Inc., manage our fixed maturity investment portfolio in accordance with investment guidelines approved by our Board of Directors.

Completed Proprietary CDOs

The following table provides certain information on the seven CDOs we have originated to date:

Originated Proprietary CDOs

($ in millions)

Name

Type

Closed

Notional
Portfolio
Size

First Loss or
Equity
Size

ACA CDS 2001-1

CDS

01/25/02

1,000

22.5

ACA CDS 2002-1

CDS

06/26/02

1,000

22.0

ACA ABS 2002-1

ABS

07/29/02

400

18.0

ACA CDS 2002-2

CDS

04/09/03

1,000

25.0

ACA ABS 2003-1

ABS

05/20/03

400

18.0

Grenadier Funding Ltd

ABS

07/21/03

1,500

22.5

ACA ABS 2003-2

ABS

11/06/03

725

33.5

New Accounting Pronouncements

In January 2003, the FASB issued FIN No. 46, "Consolidation of Variables Interest Entities". FIN 46 relates to the consolidation of variable interest entities in which the equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties or the equity investors lack essential characteristics of a controlling financial interest. We adopted the provisions of FIN 46 in the year ended December 31, 2003. As a result of the adoption of FIN 46 and previous accounting pronouncements, we have consolidated five of our seven currently outstanding CDOs which has resulted in an increase in both our assets and our liabilities. There was no material impact on our financial statements as a result of this implementation.

In April 2003, FASB issued FAS No. 149, "Amendment of FASB Statement No. 133 on Derivative Instruments and Hedging Activities." This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FAS 133. This Statement is effective for contracts entered into or modified after June 30, 2003, except for the provisions of this Statement that relate to FAS 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003 and for hedging relationships designated after June 30, 2003. All provisions are to be applied prospectively, except for the provisions of this Statement that relate to FAS 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003. These provisions are to be applied in accordance with their respective effective dates. We do not foresee that the implementation of this statement will have a material impact on our financial statements.

In May 2003, the FASB issued FAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity." The statement requires the issuer of such financial instruments to classify these items as liabilities on its balance sheets. We do not foresee the implementation of this statement having a material impact on our financial statements since the only financial instruments that we own with such balance sheet qualities is our trust preferred debt, which is currently classified as a liability on our balance sheet.

On December 23, 2003 the FASB released revised FASB Statement No. 132 (FAS 132), "Employers' Disclosures about Pensions and Other Postretirement Benefits." The revised standard provides required disclosures for pensions and other postretirement benefit plans. The revised standard replaces existing pension disclosure requirements. The requirements of the standard are effective for public entities for fiscal years ending after December 15, 2003 and for quarters beginning after December 15, 2003, unless otherwise stated in the standard. We do not anticipate that the implementation of this statement will have a material impact on its financial statements.

INDUSTRY OVERVIEW

The Municipal Finance Market

Financial guaranty insurance is a form of credit enhancement that unconditionally and irrevocably guarantees payment, when due, of the principal of and interest on third party payment obligations. Financial guaranty insurance is principally offered as a credit enhancement to municipal bonds, to corporate credits and to asset-backed securities. Insurance can be provided on all or a portion of an issue of securities at the time of original issuance or to holders of all or a portion of an issue of uninsured obligations at any time following issuance. Financial guaranty insurers seek to minimize the risk inherent in the liabilities they guarantee by maintaining diverse portfolios, thereby spreading risk with respect to a number of criteria, including issue size, type of bond, type of collateral and geographic area. Financial guaranty insurers employ various techniques such as reinsurance and single risk limits to maintain the diversity of their insured portfolios.

Financial guaranty insurance benefits both the underlying issuer and the investor. The issuer benefits because its securities are generally sold with a higher credit rating than securities of the same issuer sold without financial guaranty insurance. With respect to the insurance of municipal bonds, this can result in significant interest cost savings to issuers, and therefore to taxpayers as well. The Association of Financial Guaranty Insurors estimates that in 2002, the most recent year for which data is available, U.S. municipal issuers saved approximately $2.8 billion in borrowing costs because of lower interest rates resulting from the use of bond insurance. In addition to reducing borrowing costs, financial guaranty insurance also generally results in superior marketability of insured securities both at issuance and in the secondary market. Furthermore, for complex financings and obligations of issuers that are not well known by investors, insured obligations can receive greater market acceptance than obligations without insurance, and may help a lesser known issuer execute a financing it otherwise might have been unable to complete.

One of the most important benefits to investors in insured financial obligations is that the risk of loss associated with an issuer's default is significantly mitigated. An additional benefit is the price stability that the guaranty or insurance creates in volatile or distressed situations. When comparing insured bonds to uninsured bonds issued by the same obligor, insured bonds have fared significantly better in terms of price stability through times of stress (e.g., recession when credit spreads widen). This is a significant consideration for investors, especially for those who mark their investments to market.

One important measure investors, clients and others look to in evaluating a financial guarantor is its claims-paying ability or insurer financial strength rating assigned by one or more of the major rating agencies. The major rating agencies evaluate bond insurers to determine whether the insurer's capital is adequate to satisfy its obligations during potential stress scenarios and to confirm that the insurer is maintaining appropriate financial flexibility. For more information on the meaning of the ratings assigned by S&P and Fitch see Appendix A.

The municipal finance market in the United States includes debt issued by states, political subdivisions (e.g., cities, counties and towns), utility districts, airports, higher educational institutions, hospitals, transportation and housing authorities and other similar authorities and agencies. These obligations are generally supported by either the taxing authority of the issuer or the issuer's or underlying obligor's ability to collect fees or assessments for certain projects or public services.

The following table sets forth certain information regarding long-term U.S. municipal new issues sold during the periods indicated:

Insured Obligations(1)


Year	New Total Volume		New Insured Volume		New Insured Volume as Percent of New Total Volume
	(dollars in billions)
1995	$	160.4	$	68.6		42.8	%
1996		185.2		85.7		46.3
1997		220.7		107.5		48.7
1998		286.7		145.6		50.8
1999		227.6		105.6		46.4
2000		200.7		79.3		39.5
2001		288.3		134.2		46.5
2002		358.8		178.9		49.9
2003		384.2		190.1		49.5

(1)	Information is based on data provided in The Bond Buyer, February 6, 2004. Volume is expressed in terms of par insured.

Insurance of municipal obligations historically has been the largest portion of the financial guaranty insurance industry. The issuance of municipal obligations is predominantly driven by the prevailing interest rate environment, but is also subject to the timing of the financing needs of certain municipal issuers. Both total new issuance of municipal obligations and refundings of previously issued municipal obligations increased in 1996, 1997 and 1998, primarily due to lower interest rates. In 1999, rising interest rates caused a decrease in refundings, which was responsible for much of the decline in total issuance that year. The year 2000 saw a further decline in both total municipal issuance and the percentage of municipal par insurance. This was attributable in part to the effect of budget surpluses reducing municipal borrowing needs, as well as the strengthened credit ratings of municipal issuers. In 2001, new issue volume grew due, in part, to a declining interest rate environment, and insurance penetration returned to approximately the same level as in 1999. Volume increased in 2002 as low interest rates, diminished tax revenues and continuing needs for infrastructure investment drove municipalities to borrow at unprecedented levels. Between 1995 and 2002 approximately 47% of new municipal issues utilized bond insurance, and in 2003 approximately 50% of new municipal issues utilized bond insurance.

The market for "A" rated insurance of new issues of municipal obligations is a subset of the municipal finance market and consists of lower investment grade and below investment grade or unrated issues not historically served by the "AAA" financial guaranty insurance industry. It is a market that is relatively less driven by the prevailing interest rate environment and more driven by the timing of the financing needs of certain municipal issuers that are infrequent participants in the municipal finance market. Further, refundings have not to date comprised a significant portion of this market. The following table sets forth certain information regarding long-term U.S. municipal new issues sold by low or non-rated issuers during the periods indicated:

Municipal New Issues—Low Investment Grade(1) and
Non-Investment Grade/Non Rated(2)


Year	Par Amount		Number Of Issues
	(dollars in billions)
1995	$	26.4		4,221
1996		23.6		4,459
1997		23.4		4,342
1998		30.0		4,780
1999		30.8		4,679
2000		23.3		3,643
2001		24.5		3,772
2002		22.8		3,756
2003		36.2		4,309

(1) Low investment grade includes any issue rated in the "BBB" category by a nationally recognized statistical rating organization.

(2) Source: Securities Data Corp. as of February 6, 2004.

The Collateralized Debt Obligations (CDO) Market

The CDO market is a subset of the asset-backed securities, or structured finance, market. The asset-backed securities market consists of transactions in which a stream of payments derived from specified assets is packaged as a security and sold in the capital markets in a process called "securitization." A CDO is a securitization of financial instruments. For example, an ABS CDO is a repackaging of asset-backed securities and a CDS CDO is a repackaging of credit default swaps combined with income bearing securities. A credit default swap is a contract that involves the transfer of credit risk without the transfer of the associated assets. A typical credit default swap provides for reimbursement to the risk-transferor for any loss of par of the associated asset in the event of a default or upon the occurrence of another specified credit event.

Although the first CDOs were issued in the late 1980s, annual aggregate issuance remained below $1.5 billion until 1996, when issuance volume increased to approximately $15 billion. By 2003, CDO issuance volume in the U.S. had grown to approximately $150 billion. The following table depicts CDO issuance in the United States from 1997 through 2003:

U.S. CDO Issuance 1997-2003


Year	CDO Issuance
	(dollars in billions)
1997	$	36.2
1998		74.9
1999		86.7
2000		113.7
2001		139.6
2002		123.0
2003		150.4

Source: Bear, Stearns & Co. Inc., "CDO Perspectives: January 2004."

Global issuance of CDOs totaled approximately $227 billion in 2002 and approximately $343 billion in 2003. Investment grade CDOs have contributed significantly to CDO new issuance since 2000, when they represented only 3% of the global market. In 2003, the investment grade CDO share of the U.S. market grew to 44% and to 73% in the European market.

CDOs enable financial institutions to manage their risk profiles, optimize capital utilization, manage market price volatility and improve returns on equity by transferring risks from their balance

sheets, either through the sale of assets to CDO vehicles or by entering into credit default swaps with CDO vehicles. A credit default swap has the further benefit of allowing a financial institution to transfer risk without the legal or economic transfer of assets. CDOs are also used by dealers and portfolio managers to provide leveraged investments in diversified asset portfolios. The investor base for both ABS CDOs and CDS CDOs presently is comprised largely of banks, money managers and insurance companies. Managed tranches of the CDO are structured to appeal to different investor groups with varying appetites for risk. The managed aspect of CDOs allows new classes of investors to participate in asset classes they would not otherwise invest in due to the costs of information gathering. As a result, CDOs deepen and broaden the market for the underlying assets.

CDO Structures

The basic CDO is generally structured with a bankruptcy remote special purpose entity, commonly referred to as an SPE. In an ABS CDO, the SPE purchases an underlying portfolio of previously issued ABSs. An ABS CDO applies the income it receives from the portfolio of ABSs it has purchased to pay interest and principal on the securities it has issued. The purchase price for the portfolio is funded by the SPE through the issuance of its own securities. For CDS CDOs, the SPE assumes credit risk not by directly holding collateral but by entering into one or more credit default swaps that reference such obligations. The CDS CDO funds the collateral for its obligations under these credit default swaps by issuing its own securities either in funded form or in synthetic or credit derivative form. A CDS CDO applies the income it receives from the credit default swap to pay interest and principal on the securities it has issued.

The securities issued by the SPE in a CDO represent undivided interests in the assets of the SPE, and are divided into layers, also known as tranches or classes, with decreasing priority of claims on the cash flows from the collateral (e.g., Class AA, Class B, Class C, Class D, etc). Each tranche of securities is subordinated to the tranche or tranches above it in the right to receive principal and interest. The last tranche to be paid is also the first tranche to suffer a loss and is often referred to as the first loss tranche or the equity tranche. Each of the tranches is assigned a credit rating, except for the equity tranche which is unrated. The difference between the annual cash flow to the CDO and the annual interest payments to the rated securities is called the excess spread. The excess spread is paid to the equity tranche and can be reduced by payment defaults in the underlying portfolio. The credit protection for the rated tranches comes from the overcollateralization provided by the equity and junior tranches and from the excess spread.

If a CDO is actively managed, the portfolio manager will direct the selection and acquisition of the assets and will monitor the credit performance of the CDO assets for compliance with the CDO's requirements for diversification and asset quality, replacing poor performing underlying assets when necessary. Many CDOs have revolving periods where distributions from the underlying assets are re-invested in additional assets.

The following chart illustrates the typical structure of an ABS CDO:

CDS CDOs

A CDS CDO generates income (and takes on risk) when it enters into credit default swaps. The CDO vehicle, which is the special purpose entity into which the underlying securitized assets of a CDO are placed, is paid a swap premium for each credit default swap on which it sells protection. When a credit event with respect to a credit default swap occurs during the term of the CDS CDO, the CDO vehicle (as the party who has taken on credit risk) must compensate the counter-party to the credit default swap. This is accomplished in one of two ways. The CDO vehicle either delivers in cash the notional amount, which is the payment obligation on the credit default swap, and accepts, in return, a security issued by the entity referenced in the credit default swap (physical settlement) or makes a cash payment to the counter-party that amounts to the difference between the notional value of the credit default swap less the market price of the defaulted asset (cash settlement). In order to satisfy the credit requirements of the credit protection buyer (the CDO vehicle's counterparty), the CDO vehicle sets up a credit-protection account with the proceeds from the sale of the CDO's securities or with insurance policies or credit derivatives sold by counterparties willing to offer credit protection to the CDO vehicle. If the CDO vehicle issues securities, it invests the proceeds in highly-rated securities. Otherwise, if securities were not issued, the CDO vehicle instead pledges insurance contracts or credit derivatives against its obligations. The principal in this account or the credit derivatives or insurance policies are used as collateral for potential payments the CDO vehicle would make upon the occurrence of a credit event. Any income from this account, like the premium amounts received on the credit default swaps, are paid to the holders of the CDO's securities.

An important structural feature of the CDS CDO is the most senior liability in the structure, which is commonly referred to as the super-senior tranche. The CDO vehicle and the super-senior investor enter into a credit default swap whereby the CDO vehicle agrees to pay an ongoing premium to the super-senior investor in return for a commitment by the super-senior buyer to compensate the CDO vehicle for defaults in the reference portfolio after the credit protection account is depleted. Since the credit quality of the reference pool is investment grade and the credit-protection account provides the first loss protection, the risk taken on by the super-senior investor is remote. Because of this remoteness and the fact that the super-senior buyer is often a triple-A rated entity, the CDO

vehicle enters into the super-senior swap on an unfunded basis. This means that the super-senior investor is not required to make any initial commitment of capital. In return for accepting the risk of the super-senior swap, the investor is paid a risk premium. The unfunded nature of the super-senior tranche allows a CDS CDO to have a large notional amount of reference credits while requiring its investors to fund a much smaller amount.

The following chart illustrates the typical structure of a CDS CDO:

BUSINESS

Overview

ACA Holdings conducts business through its subsidiaries in the following areas:


•	Municipal Bond Insurance: We provide financial guaranty insurance primarily in connection with our credit enhancement of underserved segments of the municipal finance market.

•

Financial Services: We participate in the market for CDOs. We originate and structure CDOs as well as manage the financial assets that comprise the CDOs. Originating and structuring CDOs generally involves the acquisition of corporate obligations or asset-backed securities and the packaging of these obligations and securities within an investment entity. The investment entity issues debt obligations to institutional investors, and these obligations are repaid with the cash flows from the underlying obligations and securities.


•	Customized Solutions: In addition to our financial guaranty insurance, we also provide other types of specialized insurance products for the financial and insurance markets.

Our financial guaranty insurance business has an "A" financial strength rating from S&P and Fitch. We use our financial guaranty insurance to enhance the credit rating of lower-rated and non-rated municipal bonds to an effective "A" rating. This allows municipal bond issuers to borrow at a lower cost and increases the marketability of their bonds.

We receive premiums from municipal bond issuers in exchange for providing insurance against payment defaults. Nearly half of all municipal bonds outstanding carry some form of financial guaranty insurance, and the vast majority of insured municipal bonds are insured by financial guarantors whose credit ratings are "AAA". Due to both rating agency and internally imposed constraints, these "AAA" financial guarantors generally do not insure non-investment grade or non-rated municipal bonds. By contrast, our "A" financial strength rating combined with our expertise in credit analysis allows us to guarantee the bonds of issuers in this underserved segment of the market. As of December 31, 2003, we had insured obligations consisting of $8.6 billion net par outstanding, $5.6 billion of which represents our insured municipal bond portfolio. From our inception in 1997 through December 31, 2003, our paid losses and expenses relating to the settlement of losses, net of recoveries, have been less than 1% of the total net insurance premiums we received during this period.

Within our financial services business, we receive fees for originating, structuring and managing the financial assets that comprise CDOs:


•	We originate CDOs by collaborating with financial institutions, such as investment banks, to create new CDOs and assist in the selection and acquisition of the financial assets that will comprise the CDO.

•

of the total assets of the CDO, is also known as the "first-loss" layer because it absorbs any initial losses on the financial assets of the CDO. By assuming the risk associated with the equity layer, we become entitled to the difference, often referred to as excess spread, between the payments the CDO receives from the underlying financial assets of the CDO and the payments that the CDO makes to holders of its debt obligations. We believe that this approach increases and diversifies our economic return by complementing our fee-based revenue with risk-based revenue. We completed our first CDO in January 2002 and have completed a total of seven transactions to date with $6.0 billion of CDO assets under management.


•	Financial guaranty insurance of the most senior liability, commonly referred to as the "super-senior" tranche, of CDOs structured by third parties.


•	Reinsurance of discrete amounts that allows us to selectively participate in the property catastrophe insurance market.

For the year ended December 31, 2003, we had total revenues of $108.0 million and net income of $17.2 million. Our shareholders' equity was $194.3 million at December 31, 2003.

Competitive Strengths

We believe we possess the following competitive strengths:


•	Focus on credit analysis and risk management.


•	Use of "A" financial strength rating to provide financial guaranty insurance to underserved segments of the municipal finance market.


•	Unique approach to structured finance.


•	Management team with significant industry and operating experience.

Focus on credit analysis and risk management. We emphasize the importance of rigorous credit analysis throughout our insurance and financial services businesses. In our insurance operations we have developed an expertise in analyzing non-traditional lower investment grade, non-investment grade and unrated municipal credits. In our financial services operations, our CDO asset selection and asset management strategies are based on extensive review and monitoring of credits on an individual and portfolio basis. We support our credit decisions across both of these businesses with extensive quantitative analysis, risk assessment and management and portfolio surveillance using proprietary software systems. Our focus on credit analysis is evidenced by the fact that since inception our paid losses and expenses relating to the settlement of losses, net of reinsurance recoverables and salvage from obligors, have been less than 1% of the total insurance premiums we received during this period.

Use of "A" financial strength rating to provide financial guaranty insurance to underserved segments of the municipal finance market. We are currently the only financial guarantor that has an "A" financial strength rating. All other financial guarantors that serve the municipal finance market are rated "AAA" or "AA." Insurers with "AAA" or "AA" ratings generally are not able or choose not to guarantee the bonds of non-investment grade and non-rated issuers due to both rating agency and internally imposed constraints. By contrast, our "A" financial strength rating combined with our expertise in credit analysis allows us to provide financial guaranty insurance to these underserved issuers. We carefully analyze each issuer we insure to mitigate the increased risk associated with the low or non-existent underlying rating of their bonds.

Unique approach to structured finance. Through our participation in the CDO market, we receive both fee-based and risk-based revenues while limiting our risk of economic loss to the first loss

layer of a CDO. This provides us with higher returns than would be available if we acted solely as a traditional financial guarantor by insuring debt obligations of the CDO, while also limiting our risk. This approach emphasizes capturing diverse revenue streams. We are paid structuring fees for originating CDOs, asset management fees for actively managing the underlying credits, and additional income related to our participation in the equity of the CDO. We are able to efficiently leverage our capital by using our financial guaranty insurance to facilitate our participation in the first loss layer of the CDOs. By receiving multiple revenue sources, we can create a more conservative CDO portfolio than is typical and still attain our return hurdles objectives. In addition, we believe that our ability to manage the underlying financial assets of the CDO allows us to mitigate losses as they develop, and to lower the risk of defaults by trading out of financial assets of the CDO that develop credit issues.

Management team with significant industry and operating experience. Our management team is led by our Chief Executive Officer, Michael Satz. Mr. Satz has worked in the financial guaranty insurance and structured finance markets for 22 years, having served previously as Chief Executive Officer and Chairman of Capital Re Corporation and before that, as Chief Operating Officer and General Counsel of the predecessor company to Ambac Financial Group. In addition, our senior management team collectively averages over 17 years in the financial services industry.

Business Strategy

Our goal is to generate recurring revenues that will provide returns on our capital, adjusted for risk, that are superior to those of our competitors by adhering to the following strategies:


•	Capitalize on the flexibility of our "A" financial strength rating.


•	Pursue growth opportunities in underpenetrated segments of the municipal finance market.


•	Continue the origination of our CDOs.


•	Seek diversified revenues from multiple sources.


•	Offer new insurance products and services to our clients and expand geographically.

Capitalize on the flexibility of our "A" financial strength rating. Our "A" financial strength rating from both S&P and Fitch affords us the flexibility to participate in our chosen markets. In the municipal finance market, our "A" financial strength rating allows us to provide financial guaranty insurance to issuers that are historically underserved by "AAA" rated financial guarantors. Because of the number of active market participants, premium levels for "AAA" or "AA" financial guaranty insurance are quite competitive. By contrast, we can charge premiums that reflect the greater risk we assume. We intend to continue to capitalize on the advantages that we believe our "A" financial strength rating affords us.

Pursue growth opportunities in underpenetrated segments of the municipal finance market. From the early 1980s to the mid-1990s, the growth of the "AAA" financial guaranty industry accelerated as insurance was increasingly used to facilitate the distribution of municipal bonds. The volume of insured bonds increased and a discrete market for "AAA" insured bonds was established. We target the lower- or non-rated segment of the municipal finance market, which we believe has strong growth potential. We believe that our segment of the municipal finance market will similarly evolve from the current low level of insured penetration, which we estimate to be less than 4% in 2002. As issuers in this segment seek financial guaranty insurance, we believe our established reputation as a long-time provider to this market segment will give us an advantage over other potential competitors.

Continue the origination of our CDOs. We intend to continue to originate, structure and manage the assets of new CDOs. We believe that we can build on our track record of managing CDOs, which should enhance market reception to our new CDOs with new asset classes.

Seek diversified revenues from multiple sources. We intend to maintain the diversity of our revenues, including fees, premiums and investment income. In addition, we will continue to generate revenues from multiple sources, including municipal finance, structured finance and other insurance products. We believe the municipal credit default risk assumed in our municipal finance business, the

credit default risk assumed in our financial services business, and the risks assumed in our customized solutions business are generally uncorrelated. We intend to continue to generate diverse revenue streams from both risk assumption (insurance premium and CDO equity tranche returns) and financial services (asset management and CDO structuring fees). We believe that this approach will limit our exposure to negative cycles in one or more of these markets.

Offer new insurance products and services to our clients. We intend to use our expertise in credit analysis and quantitative risk management to create and offer new products for the insurance and structured finance markets.

History

We began operations in September 1997 as an "A" rated financial guarantor. Late in 2000, in response to ratings pressure and deteriorating capital position, our board of directors hired new senior management and undertook a process to raise additional capital and to revise and expand our business model. Under the direction of the new management team, the focus of the municipal finance business was redirected from volume and revenue targets to transactional profitability. In addition, in our financial services business, we discontinued the insurance of most third-party transactions and instead began originating our CDOs. We redomesticated our holding company to Bermuda in 2002.

We carry out our U.S. insurance operations through ACA Financial Guaranty and our non-U.S. insurance operations through ACA Bermuda and ACA Solutions. We carry out our financial services operations through our non-insurance subsidiaries, which include a registered broker-dealer and an asset management company registered under the Investment Advisers Act of 1940.

Our principal executive office is located at 44 Church Street, Hamilton HM 12, Bermuda and our telephone number is (441) 295-3688. We maintain a website at www.aca.com on which we will post all reports we file with the Securities and Exchange Commission, or the SEC, under Section 13(a) of the Securities Exchange Act of 1934, or the Exchange Act, after the closing of this offering. We also will post on this site our key corporate governance documents, including our board committee charters, our code of conduct and our principles of corporate governance. Information on our website is not, however, a part of this prospectus.

Insurance Operations

We offer financial guaranty insurance that (i) provides protection against payment defaults in the municipal bond market and customized risk protection in the insurance market and (ii) supports our involvement in the structured finance market by facilitating our ability to borrow funds to purchase the equity tranche of our CDOs issued by special purpose entities or to insure the first loss layer of our synthetic CDS CDOs. We provide financial guaranty insurance primarily to underserved segments of the municipal finance market. We offer customized insurance products that assist financial institutions in meeting their regulatory, accounting or capital requirements. Our products may take the form of direct insurance or structured credit derivatives backed by our financial guaranty insurance.

The table below depicts our net par exposure at the end of the last three years:

Total Net Par Exposure


	As of December 31,
	2003		2002		2001
	($ in millions)
Municipal	$	5,604	$	4,693	$	4,062
Non-Municipal		2,959		1,685		1,501
Total	$	8,563	$	6,378	$	5,563

The following table is a breakdown of net premiums written by ACA Financial Guaranty during the last three fiscal years by type of transaction. For a more detailed discussion of the results of our insurance operations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations."

Insurance Operations Net Premiums Written


	Years ended December 31,
	2003		2002		2001
	($ in millions)
Municipal	$	46.1	$	38.1	$	(0.4	)
Non-municipal
Customized solutions		14.3		7.4		5.9
Structured finance		2.1		1.9		—
Total	$	62.5	$	47.4	$	5.5

Our financial guaranty insurance policies unconditionally and irrevocably guarantee to the holder of the underlying obligation the payment of the principal and interest on the insured obligation in accordance with the original payment schedule, with no provision for mandatory acceleration of our liabilities by the holders without our consent, regardless of the terms of the insured obligations. In the event we are required to make payments under our financial guaranty, we become subrogated to the right to payment that the holder has against the issuer, meaning that we have recourse against the issuer and any related collateral for amounts paid under the policy.

The premiums for our financial guaranty insurance are non-refundable and are payable by the issuer of the debt obligation either in full at the policy's inception, as is generally the case with municipal bonds, or in periodic installments, as is generally the case with structured finance obligations. For financial reporting and statutory accounting purposes, we recognize periodic installment premiums when received and recognize premiums that are paid in advance over the term of the related risk. We determine premium rates based on the type of transaction and our assessment of the risk we are assuming. Factors we consider in setting premium rates include:


•	the credit strength of the obligor;


•	the obligor's sources of income and available liquidity;


•	any collateral pledged to secure the insured obligation;


•	restrictive covenants in the instruments under which the debt obligations are issued;


•	size, type and maturity of the issue;


•	prevailing market spreads between the insured obligation and uninsured obligations with similar characteristics, as a market indicator of relative credit quality;


•	our cost of the capital used to support the risks, including rating agency capital charges, and our projected return;


•	the interest rate spread between the insured obligation and uninsured obligations with similar characteristics, to define the potential value of the financial guaranty;


•	competition from other providers of credit enhancement; and


•	alternatives to financial guaranty insurance.

Premium rates are typically calculated as a percentage of the principal and interest scheduled to come due during the stated term of the insured obligation. In most instances, we have been able to price our financial guaranty business to capture the majority of the difference in borrowing cost, or spread, between our insured bonds and the same bonds if uninsured. In 2003, this resulted in an average price of 2.22% of insured principal and interest in our municipal bond insurance business. This compares to an average price of 0.5%, for the "AAA" rated financial guaranty insurers in 2002, the most recent year for which data is available.

Municipal Insurance Operations

We target segments of the municipal finance market that are historically underserved by "AAA" rated financial guarantors. Insurers with "AAA" or "AA" ratings generally do not insure lower

investment grade, non-investment grade and non-rated issuers primarily due to rating agency requirements and internal constraints. As of December 31, 2003, approximately 57% of our portfolio was investment grade with approximately 54% of the portfolio rated "BBB." We also provide financial guaranty insurance on financial obligations that are unrated or are non-investment grade but that in our opinion either have inherent credit characteristics or have been sufficiently enhanced by additional security to support our strong expectation of timely payment.

The table below shows the diversification of our insured municipal portfolio by underlying credit quality as of December 31, 2003:

Insured Municipal Portfolio Credit Quality


Credit Quality	Percentage of Portfolio
AAA		0.0	%
AA		0.0
A		2.3
BBB		54.4
Non-investment grade		37.0
Non-rated		6.3
Total		100.0	%

We also actively participate in the secondary market for municipal bonds. During 2003, approximately 92.5% of our municipal written premiums were derived from new issues and 7.5% from secondary market transactions. Typically, a holder of outstanding bonds in the secondary market will purchase financial guaranty insurance to facilitate the future sale of the bonds. Clients include institutional investors, bond traders, portfolio managers and underwriters. A financial guaranty insurance policy affords access to a broader secondary market in insured bonds and therefore greater marketability. A financial guaranty insurance policy will also support the market value of the insured bond if the underlying credit is distressed. As is the case with new issues, the premium is generally payable in full at the time of policy issuance. We employ the same underwriting standards for secondary market issues that we do for new issues. The secondary market also provides us with the opportunity to diversify our insured portfolio.

We originate our municipal bond insurance business both through referrals and our internal sales force. A substantial portion of ACA Financial Guaranty's net par written in 2003 was the result of referrals from investment banks, financial advisors and previously insured issuers or obligors. In addition, as of December 31, 2003, ACA Financial Guaranty had a team of four experienced sales personnel responsible for identifying potential municipal bond insurance transactions and educating participants in the municipal bond market about the value of our "A" rated insurance. We generate interest in our secondary market capability by pre-approving municipal bonds for our insurance. We then communicate the availability of our insurance capacity to the market through on-line systems such as Bloomberg, direct e-mail and our website. In addition, we review our current clients' portfolios for insurance opportunities.

Description of Our Insured Municipal Portfolio

We seek to maintain an insured portfolio designed to manage risk by means of diversification based on a variety of criteria including revenue source, issue size, type of asset, industry concentrations, type of bond and geographic area. As of December 31, 2003, we had 739 municipal policies outstanding. These policies are diversified among 352 "credits," which we define as any group of bond issues supported by the same revenue source.

Our insured portfolio of municipal bonds is divided into the following major types:

General Obligation Bonds. General obligation or full faith and credit bonds are issued by states, their political subdivisions and other municipal issuers and are supported by the general obligation of the issuer to pay the bonds from available funds and by a pledge of the issuer to levy sufficient taxes to provide for the full payment of the bonds.

Tax-Supported (Non-General Obligation) Bonds. Tax-supported bonds include a variety of bonds that are supported, not by a general obligation, but instead by a specific tax source, and include tax-backed revenue bonds and general fund obligations of the issuer, such as lease revenue bonds. Tax-backed revenue bonds may be secured by a lien on pledged tax revenues, such as revenues from special taxes, including retail sales and gasoline taxes, or from tax increments (or tax allocations) generated by growth in property values within a district.

Higher Education Bonds. Higher education bonds that we insure consist primarily of bonds issued to finance the construction of educational facilities. As an example, we insure student housing projects that have strong demand characteristics, involvement by established universities, including participation in the marketing and referral to the facility, and experienced management. In addition, for new construction projects, we require that other insurance and debt service guaranties, or capital, cover completion and certain stabilization risks.

Health Care Revenue Bonds. Health care revenue bonds include long-term financings for capital construction or improvements of health care facilities typically secured by a general reserve pledge and an underlying mortgage note of the not-for-profit corporation owning and operating the individual hospital or health care system. To date, our focus has been on insuring the debt of acute care hospitals that are sole community providers in rural areas or specialty providers of essential services.

Long-Term Care Bonds. Long-term care bonds that we insure consist primarily of long-term financings for capital construction or improvements of continuing care retirement communities, or CCRCs. CCRCs are organizations that offer a full range of housing, residential supportive services and healthcare to residents of retirement age. We insure the debt of CCRCs that have been operating with strong demand and stabilized occupancy or are being built to augment established operations.

Transportation Revenue Bonds. Transportation revenue bonds include a wide variety of revenue-supported bonds, such as bonds for airports, ports, tunnels, municipal parking facilities, toll roads and toll bridges.

Municipal Utility Revenue Bonds. Municipal utility revenue bonds include obligations of all forms of municipal utilities, including electric, water and sewer utilities. Insurable utilities may be organized as municipal enterprise systems, authorities or joint-action agencies.

Housing Revenue Bonds. Housing revenue bonds include affordable multifamily housing bonds, with varying security structures based on the presence of underlying mortgages, reserve funds, and various other features.

Investor-Owned Utilities Bonds. Pollution control bonds or industrial development bonds are issued to finance projects of investor-owned utilities. The bonds are secured by the senior credit or first mortgage obligation of an investor-owned utility, typically an electric distribution utility.

Other Municipal Bonds. Other types of domestic municipal bonds insured by ACA Financial Guaranty include private college and university revenue bonds, and financings for stadiums, government office buildings, recreation facilities, resource recovery facilities, prison facilities and cultural institutions. These bond types are typically secured by a combination of project-related fee revenue, lease payments and/or other support of a state or local governmental entities.

The tables below show the diversification of our municipal finance insured portfolio, which represents 65.4% of our total insured portfolio, by bond type as of December 31, 2003:

Municipal Insured Portfolio by Bond Type
($ in millions)


Bond Type	Net Par Exposure		Percent of Municipal Portfolio
General obligations and tax-supported	$	1,426		25.5	%
Higher education		1,163		20.7
Acute health care revenue		927		16.5
Long-term care		495		8.8
Transportation revenue		410		7.3
Municipal utility revenue		289		5.2
Housing revenue		233		4.2

AMERICAN CAPITAL ACCESS HOLDINGS LTD S-1/A