developments related to bankruptcies of companies insofar as they affect property and casualty insurance and reinsurance coverages or claims that we may have as a counterparty;
We continue to develop new business opportunities in several areas, including our North American construction and surety businesses, which were announced in 2010, and our political risk and trade credit, and North America inland marine businesses, which were announced during the fourth quarter of 2011. We also continue to expand existing businesses such as adding property, excess auto and excess liability to our excess & surplus business and expanding local underwriting in our North America excess casualty business by adding underwriters in Dallas, Atlanta and Exton, PA. Geographic expansion also continues with the opening of an office in China in April 2011 and an office in Brazil in June of 2012-complementing the Reinsurance operation with an Insurance segment branch offering Casualty, Property, Professional and Specialty products.
As noted above, the pricing environment on the primary side is showing rate growth but both the primary and reinsurance markets remain highly competitive with substantial capacity available in both traditional and non-traditional forms. In general, January 1 renewals saw pricing in line with management’s expectations, with positive pricing across the loss impacted catastrophe books of business and certain specialty lines, while casualty lines remained highly competitive.
In 2012, Operating ROE was 6.2%, which was 5.3 percentage points higher than 2011 when it was 0.9%. This was the result of the lower operating net income in 2011 due to the significant catastrophe losses and other large loss events, both discussed under “Significant Items Affecting the Results of Operations.” A reconciliation of Net income (loss) attributable to ordinary shareholders to operating net income (loss) is provided at “Reconciliation of Non-GAAP Measures” included herein.
On January 15, 2012, the $600 million principal amount outstanding on the XLCFE Notes, which were issued by XL Capital Finance (Europe) plc, was repaid at maturity. For further detail, see Item 1, Note 13, “Notes Payable and Debt Financing Arrangements,” to the Consolidated Financial Statements included herein.
IBNR reserves are calculated by our actuaries using standard actuarial methodologies as discussed above. Since the year ended December 31, 2003, we adopted a methodology that provides a single point reserve estimate separately for each line of business and also a range of possible outcomes across each single point reserve estimate. This is discussed further below.
We also provide reinsurance of term assurance and critical illness policies written in the U.K., Ireland and the United States. The future policy benefit reserves for these contracts amounted to approximately $271 million and $241 million at December 31, 2012 and 2011, respectively. This increase was caused by ageing of the portfolio, combined with movements of the U.K. sterling and Euro against the U.S. dollar over 2012. Future policy benefit reserves include the lock-in of assumptions at inception with periodic review against experience. The provisions for adverse deviation in these reserves amounted to approximately $24 million and $22 million at December 31, 2012 and 2011, respectively.
We evaluate the performance of both the Insurance and Reinsurance segments based on underwriting profit and the performance of the Life operations segment based on its contribution to net income. Other items of our revenue and expenditure are not evaluated at the segment level for reporting purposes. In addition, we do not allocate investment assets by segment for our P&C operations. Investment assets related to our Life operations and certain structured products included in the Insurance and Reinsurance segments and in Corporate are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments. See Item 8, Note 4, “Segment Information,” to the Consolidated Financial Statements included herein, for a reconciliation of segment data to our consolidated financial statements.
Foreign exchange rate movements also impacted our gross premiums written. When evaluated in local currency, our gross written premiums increased by 8.8%, compared to the 7.1% shown above.
2011 vs. 2010: The increase of 7.1% resulted from the gross premiums written increases described above partially offset by an increase in ceded premiums written of 16.7%. The increase in ceded premiums written primarily relates to:
2012 vs. 2011: The increase was mainly due to a lower interest expense as a result of an accretion rate adjustment recorded in the second quarter of 2012 based on changes in expected cash flows and payout patterns on certain structured indemnity contracts combined with an increase in net investment income as a result of a larger invested asset base.
International - there was premium growth due to new motor and marine business, as well as positive amendments to prior year premium estimates.
Performance on the alternative portfolio reflects the year ended November 30, 2012 and 2011, respectively.
$19.1 million related to medium term notes backed primarily by European investment grade credit. On certain notes, management concluded that expected future returns on the underlying assets were not sufficient to support the previously reported amortized cost. We also adjusted the estimated remaining holding period of certain notes resulting in a shorter reinvestment spectrum.
2012 vs. 2011: The net income from strategic operating affiliates was generally in line with 2011. The year on year increase of 29.4% was primarily due to losses from an insurance affiliate catastrophe bond fund in 2011.
2012 vs. 2011: The increase of 27.3% was a result of performance-based compensation costs and certain strategic corporate initiatives taking place in 2012.
The ongoing global financial crisis has led to the deterioration of economies globally, as sovereign governments have reacted to the crisis by further increasing public expenditures in order to provide stimulus and security, which has created significant budgetary shortfalls. Several key nations within the European Union - particularly Greece, Italy, Ireland, Portugal and Spain (“GIIPS”) - have suffered a high level of fiscal distress and economic vulnerability due to overreliance on external credit sources and imprudent borrowing and other monetary practices. This has raised doubts within the global financial community as to whether these sovereign nations will remain able to service their own debt obligations both at a national and local level and as to whether the Euro will remain the currency for the European Union.
Financial instruments sold, but not yet purchased are included within “Payable for investments purchased” on the balance sheet.
The availability of letters of credit under the December 2011 Secured Credit Agreement and the March 2011 Credit Agreements is subject to a borrowing base requirement, determined on the basis of specified percentages of the face value of eligible categories of assets varying by type of collateral. In the event that such credit support is insufficient, we could be required to provide alternative security to cedants. This could take the form of insurance trusts supported by our investment portfolio or funds withheld (amounts retained by ceding companies to collateralize loss or premium reserves) using our cash resources or combinations thereof. The face amount of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of our business written by us and the loss experience of such business. In addition to letters of credit, we have established insurance trusts in the United States that provide cedants with statutory credit for reinsurance under state insurance regulation in the United States. For a discussion of collateral requirements for our Life operations, see Item 1, “Business - Segments - Life Operations Segment - Life Operations - Collateral Requirements.”
In general, all of our bank facilities, indentures and other documents relating to our outstanding indebtedness, including the credit facilities discussed above (collectively, the “Debt Documents”), contain cross acceleration or cross default provisions to each other and the Debt Documents contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of our insurance and reinsurance operating subsidiaries and minimum required levels of secured indebtedness in the future. In addition, generally each of the Debt Documents provide for an event of default in the event of a change of control of the Company or certain events involving bankruptcy, insolvency or reorganization of the Company.
A downgrade below “A -” of our principal insurance and reinsurance subsidiaries by either S&P or A.M. Best, which is two notches below the current S&P financial strength rating of “A” (Positive) and the A.M. Best financial strength rating of “A” (Stable) of these subsidiaries, may trigger cancelation provisions in a significant amount of our assumed reinsurance agreements and may potentially require us to return unearned premiums to cedants. In addition, due to collateral posting requirements under our letter of credit and revolving credit facilities, such a downgrade may require the posting of cash collateral in support of certain “in use” portions of these facilities (see “Liquidity and Capital Resources”). In certain limited
We have utilized variable interest entities in certain instances as a means of accessing contingent capital. We have utilized unconsolidated entities in the formation of contingent capital facilities.
bid indications where pricing services do not provide coverage for a particular security. To the extent the Company believes current trading conditions represent distressed transactions, the Company may elect to utilize internally generated models. The pricing services use market approaches to valuations using primarily Level 2 inputs in the vast majority of valuations, or some form of discounted cash flow analysis, to obtain investment values for a small percentage of fixed income securities for which they provide a price. Pricing services indicate that they will only produce an estimate of fair value if there is objectively verifiable information available to produce a valuation. Standard inputs to the valuations provided by the pricing services listed in approximate order of priority for use when available include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. The pricing services may prioritize inputs differently on any given day for any security, and not all inputs listed are available for use in the evaluation process on any given day for each security evaluation; however, the pricing services also monitor market indicators, customer feedback through a price challenge process and industry and economic events. Information of this nature is a trigger to acquire further corroborating market data. When these inputs are not available, they identify “buckets” of similar securities (allocated by asset class types, sectors, sub-sectors, contractual cash flows/structure, and credit rating characteristics) and apply some form of matrix or other modeled pricing to determine an appropriate security value which represents their best estimate as to what a buyer in the marketplace would pay for a security in a current sale. While the Company receives values for the majority of the investment securities it holds from pricing services, it is ultimately management’s responsibility to determine whether the values received and recorded in the financial statements are representative of appropriate fair value measurements. It is common industry practice to utilize pricing services as a source for determining the fair values of investments where the pricing services are able to obtain sufficient market corroborating information to allow them to produce a valuation at a reporting date. In addition, in the majority of cases, although a value may be obtained from a particular pricing service for a security or class of similar securities, these values are corroborated against values provided by other pricing services.
Authoritative guidance over disclosures about the fair value of financial instruments requires additional disclosure of fair value information for financial instruments not carried at fair value in both interim and annual reporting periods. Certain financial instruments, particularly insurance contracts, are excluded from these fair value disclosure requirements. The carrying values of cash and cash equivalents, accrued investment income, net receivable from investments sold, other assets, net payable for investments purchased, other liabilities and other financial instruments not included below approximated their fair values. The following table includes financial instruments for which the carrying value differs from the estimated fair values at December 31, 2012 and 2011. All of these fair value estimates are considered Level 2 fair value measurements. The fair values for fixed maturities held to maturity are provided by third party pricing vendors and significant valuation inputs for all other items included were based upon market data obtained from sources independent of the Company, and are subject to the same control environment previously described.
During the third quarter of 2011, the Company changed the manner in which it classifies fixed income securities between Fixed maturities and Short-term investments on the balance sheet and the related note disclosure. Short-term investments under the Company’s previous classification comprised investments with a remaining maturity of less than one year from the reporting date. Under this prior presentation, longer term securities were reclassified from Fixed maturities to Short-term investments as they neared maturity. Under the Company’s new classification, Short-term investments include investments due to mature within one year from the date of purchase and are valued using the same external factors and in the same manner as Fixed maturities. No reclassifications are made between Fixed maturities and Short-term investments subsequent to the initial date of purchase.
$10.3 million, and a cumulative fair value decline of greater than 50% of amortized cost. All of these securities are mortgage and asset-backed securities. These greater than 50% impaired securities include gross unrealized losses of $10.6 million on non-Agency RMBS, $14.8 million on Core CDOs and $0.6 million of CMBS holdings.
The Company has invested in investment and (re)insurance affiliates and investment management companies’ securities or other forms of ownership interests. Collectively, these investments are classified as “operating affiliates.”
Certain funds have a lock-up period and/or may also have the ability to impose a redemption gate. A lock-up period refers to the initial amount of time an investor is contractually required to remain invested before having the ability to redeem. Typically, the imposition of a gate delays a portion of the requested redemption, with the remaining portion settled in cash shortly after the redemption date.
The following represents an analysis of the net realized gains and the net unrealized gains on the Company’s alternative investment funds and private equity funds:
U.S. middle markets due to worse than expected reported loss experience primarily in the 2006 to 2011 accident years.
The Company records a specific reserve allowance for Periodical Payment Orders (“PPO”) in the U.K. motor liabilities. This allowance includes the unpaid losses for claims already settled and notified as PPO at December 31, 2012, as well as the unpaid losses for claims to be settled in the future. The future care element of the unpaid losses were discounted using an interest rate of 1.5% at December 31, 2012 reduced from 2% at December 31, 2011 to reflect the increased reserve and the yields obtained on the additional purchase of assets. Unpaid losses and loss expenses, net of reinsurance, at December 31, 2012 and 2011 on an undiscounted basis were $240.0 million and $52.8 million, respectively. After discounting of the future care element the unpaid losses and loss expenses were $148.6 million and $29.6 million at December 31, 2012 and 2011, respectively. The increase in net undiscounted unpaid losses and loss expenses between December 31, 2011 and December 31, 2012 is explained in part by the identification of a proportion of the overall UK motor reserves that will settle as Periodical Payment claims in the future. This is in addition to a revision of the assumptions underlying the PPO reserve calculation and the worse than expected settlement of claims as PPOs during 2012.
This amount excludes $1.0 billion that is also included in the revolving credit facility above.
The following table provides the total impact on earnings relating to derivative instruments formally designated as fair value hedges along with the impacts of the related hedged items for the years ended December 31, 2012, 2011 and 2010:
The periodic coupon settlements also resulted in decreases to Interest expense of $4.9 million, $10.2 million and $49.8 million for the years ended December 31, 2012, 2011 and 2010.
The Company, either directly or through its investment managers, may use derivative instruments within its investment portfolio, including interest rate swaps, inflation swaps, credit derivatives (single name and index credit default swaps), options, forward contracts and financial futures (foreign exchange, bond and stock index futures) and options such derivative instruments, primarily as a means of economically hedging exposures to interest rate, credit spread, equity price changes and foreign currency risk or, in limited instances, for investment purposes. The Company is exposed to credit risk in the event of non-performance by the counterparties under any swap contracts, although the Company generally seeks to use credit support arrangements with counterparties to help manage this risk.
All of the preferred shares discussed in this section were issued by XL-Cayman. XL-Ireland has no preferred shares outstanding and has never issued any preferred shares.
In addition, during 2003 six members, five of whom are still employed by the Company in the U.K., transferred from a defined benefit plan into a defined contribution plan. These employees have a contractual agreement with the Company that provides a “no worse than final salary pension” guarantee in the event that they are employed by the Company until retirement, whereby the Company guarantees to top-up their defined contribution pension to the level of pension that they would have been entitled to receive had they remained in the defined benefit scheme. The pension liability recorded with respect to these individuals was $3.5 million and $3.3 million at December 31, 2012 and 2011, respectively, representing the entire unfunded projected obligation.
On October 26, 2012, the Company announced that the Board of Directors of XL-Cayman resolved to pay a dividend of $8.8173 per share on XL-Cayman’s Series D Preference Ordinary Shares. The dividend was paid on January 15, 2013 to all shareholders of record as of January 1, 2013.
On February 22, 2013, the Company announced that the Board of Directors of XL-Cayman resolved to pay a dividend of $8.5575 per share on XL-Cayman’s Series D Preference Ordinary Shares. The dividend will be paid on April 15, 2013 to all shareholders of record as of April 1, 2013.
On February 22, 2013, the Company announced that the Board of Directors of XL-Cayman resolved to pay a dividend of $32.50 per share on XL-Cayman’s Series E Preference Ordinary Shares. The dividend will be paid on April 15, 2013 to all shareholders of record as of April 1, 2013.
The income tax provisions for the years ended December 31, 2012, 2011 and 2010 are as follows:
In the normal course of business, the Company enters into reinsurance contracts with certain of its other strategic affiliates, or their subsidiaries. During the years ended December 31, 2012, 2011 and 2010, these contracts resulted in reported net premiums written, net reported claims and reported acquisition costs as summarized below. Management believes that these transactions are conducted at market rates consistent with negotiated arms-length contracts.
The following is a summary of the unaudited quarterly financial data for 2012 and 2011: