Bermuda-based Security Capital Assurance Ltd. (SCA) has agreed to pay $500 million to Merrill Lynch & Co. Ltd. in exchange for the investment bank cancelling $3.5 billion in credit default swaps and ending its litigation against the bond insurer.

As part of the deal, XL Capital Ltd. will pay $1.78 billion in cash and issue eight million shares to its affiliate SCA, in a move approved by the New York Insurance Department and the Bermuda Monetary Authority (BMA).

The agreement will see Merrill Lynch terminate eight credit default swaps and the related financial guarantee insurance policies that were issued by SCA's subsidiary XL Capital Assurance Inc. (XLCA), with an insured gross par outstanding of $3.74 billion as of June 30, in return for a payment by XLCA to Merrill Lynch of an aggregate amount of $500 million.

Additionally, due to significant adverse development on loss reserves, XLCA will report negative statutory surplus and XL Financial Assurance Ltd. will report negative statutory capital and surplus, but, if the deals with Merrill Lynch and XL Capital are both successfully concluded, XLCA expects to have a positive statutory surplus and XLFA a positive total statutory capital and surplus.

SCA stopped writing new business earlier this year after posting a fourth-quarter loss of $1.2 billion. It had been in litigation with Merrill over credit derivatives it had sold to the Wall Street investment bank and brokerage.

Paul Giordano, chief executive officer of SCA, said: "The agreements with XL Capital and Merrill Lynch represent a significant step in the restructuring process of SCA and are critical to our efforts to stabilise the company.

"While we are very pleased with the progress made to date, our company remains exposed to potentially significant adverse loss development and there is still much work to be done.

"In the next phase, we will commence discussions with swap counterparties seeking to commute, terminate or restructure our remaining credit default swaps.

"The New York Insurance Department, the Bermuda Monetary Authority, the Delaware Department of Insurance and the UK Financial Services Authority, as well as our other regulators, have been extremely supportive in this process, and we look forward to continuing to work constructively with them in the future."

Matthew Elderfield, CEO of the BMA, which has been closely monitored the negotiations between XL Capital, SCA and SCA's bank counterparties to commute a series of guarantees and reinsurance agreements, said: "We welcome this agreement as it lifts a shadow of uncertainty from SCA and XL Capital and provides greater stability for the bond insurance industry.

"The agreement provides policyholders with greater confidence in future claims paying ability by improving the solvency position of SCA. It also allows XL Capital to move forward by exiting its exposure to the financial guarantee sector."