As a result of the recent developments discussed above, our Board of Directors retained Goldman Sachs & Co. as financial advisors to assist us in evaluating strategic alternatives, including raising new capital, structuring reinsurance solutions and negotiating the commutation or restructuring of certain of our financial guarantee obligations. We have also engaged Rothschild, Inc. to assist us with a comprehensive review of all strategic and reorganization options. We have been exploring various strategic options with our advisors and potential investors and counterparties and in consultation with our regulators to preserve and potentially enhance our capital resources, address the rating agencies’ requirements, and eventually restore our ratings to a level sufficient to permit us to recommence writing new business.
report for any period will be affected by the mix of policies that we wrote in that period on an “upfront” and, in that period and prior periods, on an “installment” basis. Generally, a financial guarantee insurance company with a growing in-force book of business should recognize an increasing amount of net earned premium from policies written in prior reporting periods, whether premiums are received on an upfront or installment basis. Future installments of premium on business written in a period are reported by financial guarantors as a component of adjusted gross premiums, a non-GAAP financial measure. See “-Other Measures Used by Management to Evaluate Operating Performance” for additional information. The amount of installment premiums actually realized by us in the future (and that would be otherwise reflected in revenue) could be reduced due to factors such as early termination of insurance contracts or accelerated prepayments of underlying obligations.
We are exposed to residential mortgages directly, through our guarantees of RMBS and indirectly, through our guarantees of ABS CDOs.
HELOC is an adjustable rate line of credit secured by a second lien on residential properties.
The following tables summarize our gross reserves (before the effect of reinsurance ceded) for losses and loss adjustment expenses by segment and by type of reserve as of December 31, 2007 and 2006. For an explanation of changes in these reserves, see “-Consolidated Results of Operations.”
Amount is net of $95.1 million, representing the net present value of future installment premiums at December 31, 2007 with regard to certain of our guarantees on which case reserves are recorded at December 31, 2007.
At December 31, 2007 and 2006, the loss list consisted of 21 and 4 credits, respectively, with remaining net par outstanding of $10.3 billion and $0.1 billion, respectively, against which net reserves of $706.9 million and $13.6 million have been established. The increase in net par outstanding on the loss list at December 31, 2007, as compared to December 31, 2006, resulted primarily from credit deterioration in our ABS CDO and HELOC exposures during 2007. See Note 14(a) and (b) of the Consolidated Financial Statements for further information.
Case basis reserve established represents a point estimate reflecting management’s best estimate, in its judgment, of the ultimate loss expected to be incurred on the policies. Management’s estimate was based on projections of cash flows expected from the assets supporting the guaranteed obligations’ debt service requirements, as well as qualitative factors considered by management.
The projected default rate for currently performing loans which were based on the loan’s characteristics including:
Loans that were currently delinquent were assumed to default at rates from 60-100% depending on the length and type of delinquency.
We then combined the losses on the RMBS securities and the 3rd level CDOs and compared these to our attachment and detachment points of the Inner CDO tranche to determine the amount of principal recovered. Total cash flows for the Inner CDOs were built using the amount of principal recovered, an adjusted weighted average life (“WAL”) of the tranche and the coupon rate as stated in the indenture. The adjusted WAL was taken from the trustee reports for that CDO and then lengthened by five years to reflect the slower prepayment speeds on the underlying collateral. We assumed that any principal recovered is received at the end of the adjusted WAL of the tranche. Interest is generally projected to be received in full until the adjusted WAL, except that we
HELOC transactions typically contain provisions that can result in a rapid amortization event, in which case such HELOC transactions may benefit by the funding of the new HELOC draws by a third-party. This benefit will be diminished in the event that the third-party is not legally required or is unable or unwilling to fund the draws, or if the lender suspends credit lines under certain circumstances legally permitted. A 1% decrease in the draw rate on all deals would result in an increase to our reserve of approximately $29 million.
The estimated fair value of these instruments was determined principally in reliance upon management’s judgment in regard to the appropriate rate of return which would be required by a market participant to assume the risks in our CDS contracts in the current market environment. Such rate of return was determined by management considering all the factors discussed above.
Ceded premiums in 2006 were $13.1 million, a decrease of $27.4 million, or 67.7% as compared to $40.5 million in 2005. The decrease was largely attributable to the transfer of certain business back to XLFA from XLI in connection with our IPO, offset in part by an increase in cessions to XL RE AM in connection with the management of XLCA’s single risk limits. As a result of a capital contribution to XLFA from the net proceeds of our IPO, XLFA had additional capacity to retain risk and, accordingly, canceled reinsurance of certain policies with XLI.
Net investment income of $77.7 million in 2006, increased $26.5 million, or 51.8%, as compared to $51.2 million in 2005. The increase in net investment income in 2006, as compared to 2005, was similarly due to higher average invested assets and higher new money yields. The increase in our average invested assets in 2006, as compared to 2005, was primarily attributable to the net proceeds from our IPO and the net cash inflows from our operations.
Net realized losses on investments were $2.5 million, $16.2 million, and $3.2 million in 2007, 2006 and 2005, respectively. Net realized losses in 2007 were primarily attributable to other-than- temporary impairment charges of $1.2 million and portfolio management actions relating to the management of duration, yield and exposure to certain credit risks amounting to $1.3 million. Net realized losses in 2006 were primarily due to an impairment charge of $15.1 million relating to notes acquired in satisfaction of a claim. See Note 14(d) to the Consolidated Financial Statements for a more detailed discussion. Net realized losses in 2005 were primarily attributable to portfolio management actions relating to the management of duration, yield and exposure to certain credit risks.
The following table presents the components of acquisition costs, net, for the years ended December 31, 2007, 2006 and 2005:
The outwards reinsurance agreements XLFA and XLCA have with reinsurers generally contain ratings-based triggers whereby if XLFA or XLCA, as applicable, is downgraded generally to a level of “AA/Aa2” to “A/A3,” depending upon the reinsurance agreement, the reinsurer has the right, but not the obligation, to terminate the agreement on a run-off basis. Should XLFA and/or XLCA reassume business as noted above, XLFA and XLCA will be required to hold additional capital against this re-assumed business. Further, re-assumed policies may be policies where losses are expected or may develop, further increasing our losses.
EITF Issue No. 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards”
Consolidated Statements of Operations and Comprehensive (Loss) Income for the years
On January 23, 2008, Fitch downgraded the insurance financial strength (“IFS”) ratings of XLCA, XLCA-UK and XLFA to “A” (Rating Watch Negative) from “AAA.”
In early 2008 the Company put in place additional reinsurance agreements between XLCA and XLFA, in addition to those put in place in late 2007, which are intended to mitigate the adverse effects on XLCA’s statutory solvency of future loss development, as well as mitigate the adverse effects on XLCA’s equity, as determined in accordance with GAAP, from the change in fair value of XLCA’s guarantees of CDS contracts.
continuing to investigate longer term strategic alternatives, including the restructuring of the Company’s business to facilitate the creation or raising of new capital.
In assessing whether a loss is probable, the Company considers all available qualitative and quantitative evidence. Qualitative evidence may take various forms and the nature of such evidence will depend upon the type of insured obligation and the nature and sources of cash flows to fund the insured obligation’s debt service. For example, such evidence with respect to an insured special revenue obligation such as an obligation supported by cash flows from a toll road would consider traffic statistics such as highway volume and related demographic information, whereas an insured mortgage backed securitization would consider the quality of the mortgage loans supporting the insured obligation including delinquency, default and foreclosure rates, loan to value statistics, market valuation of the mortgaged properties and other pertinent information. In addition, the Company will make qualitative judgments with respect to the amount by which certain other structural protections built into the transaction are expected to limit the Company’s loss exposure. Examples of such structural protections may include: (i) rate covenants, which generally stipulate that issuers (i.e., public finance issuers) set rates for services at certain predetermined levels (i.e., water and sewer rates which support debt obligations supported by such revenues), (ii) springing liens, which generally require the issuer to provide additional collateral upon the breach of a covenant or trigger incorporated into the terms of the transaction, (iii) consultant call-in rights, which provide, under certain circumstances, for a consultant to be engaged to make certain binding recommendations, such as raising rates or reducing expenses, (iv) the ability to transfer servicing of collateral assets to another party, and (v) other legal rights and remedies pursuant to representations and warranties made by the issuer and written into the terms of such transactions. Quantitative information may take the form of cash flow projections of the assets supporting the insured debt obligation (which may include, in addition to collateral assets supporting the obligation, structural protections subordinate to the attachment point of the Company’s risk, such as cash reserve accounts and letters of credit), as well as (to the extent applicable) other metrics indicative of the performance of such assets and the trends therein. The Company’s ability to make a reasonable estimate of its expected loss depends upon its evaluation of the totality of both the available quantitative and qualitative evidence, and no one quantitative or qualitative factor is dispositive.
The fair value of the Company’s in-force portfolio of CDS contracts represents management’s best estimate of the premium that would be required by a market participant to assume the risks in the Company’s in-force credit derivative portfolio as of the measurement date. Fair value is defined as the price at which an asset or a liability could be bought or transferred in a current transaction between willing parties. Fair value is determined based on quoted market prices, if available. Quoted market prices are available only on a limited portion of the Company’s in-force portfolio of CDS contracts. If quoted market prices are not available, fair value is estimated based on the use of valuation techniques involving management judgment. In determining the fair value of its CDS contracts, the Company uses various valuation approaches with priority given to observable market prices when they are available. Market prices are generally available for traded securities and market standard CDS contracts but are less available or unavailable for highly-customized CDS contracts. Most of the derivative contracts the Company guarantees are structured credit derivative transactions that are not traded and do not have observable market prices.
The Company’s payment obligations after a default vary by deal type. There are three primary types of policy payment requirements:
Proposed Statement of Financial Accounting Standards (“SFAS”), Accounting for Financial Guarantee Insurance Contracts
In addition, in connection with the IPO, XL Capital agreed to fund a portion of long-term compensation awarded by XL Capital to employees of SCA prior to the IPO and which remained outstanding under XL Capital’s long-term compensation plans subsequent to the IPO. In this regard, SCA reflects the full cost of the periodic charges from such long-term compensation in its earnings each period, XL Capital charges approximately 60% of such cost to SCA, and SCA records a capital contribution from XL Capital equal to the remaining 40% of such cost. The aggregate remaining future cost of such long-term compensation to SCA is approximately $1.0 million at December 31, 2007, of which SCA will pay XL Capital approximately $0.6 million and XL Capital will fund $0.4 million.
Effective October 1, 2001, XLFA entered into an excess of loss reinsurance agreement with XLI. This agreement covers a portion of XLFA’s liability arising as a result of losses on policies written by XLFA that are in excess of certain limits and are not covered by other reinsurance agreements. This agreement provides indemnification only for the portion of any loss covered by this agreement in excess of 10% of XLFA’s surplus, up to an aggregate amount of $500 million, and excludes coverage for liabilities arising other than pursuant to the terms of an underlying policy. XLFA ceded losses under this agreement aggregating $259.4 million during the year ended December 31, 2007, which is reflected in “losses and loss adjustment expenses” on the accompanying consolidated statement of operations. There were no losses ceded by XLFA under this agreement prior to 2007. At December 31, 2007 and 2006, the Company had a recoverable from XLI under this agreement of $259.4 million and $0, respectively, which is reflected in “reinsurance balances recoverable on unpaid losses” in the accompanying consolidated balance sheet. The ceded losses of $259.4 million represent the present value (discounted at 5.1%) of the full limit loss of $500 million under this agreement. The Company incurred expense under the excess of loss reinsurance agreement of $8.2 million, $0.5 million, and $0.5 million for the years ended December 31, 2007, 2006, and 2005, respectively. The expense recorded in 2007 reflects all future ceded premium that the Company will be required to pay under the reinsurance agreement over the remaining average life of the loss payments and recoveries noted above, in order for the agreement to remain in-force and the Company recover the aforementioned ceded losses.
The Company provides financial guarantee insurance policies insuring timely payment of investment agreements issued by XLAF, a wholly owned subsidiary of XL Capital. These investment agreements contain ratings triggers based on the rating of XLCA, substantially all of which were triggered upon XLCA’s recent downgrades by Moody’s, S&P and Fitch. XLAF may be required to repay or collateralize these investment agreements, and as guarantor of XLAF’s obligations, XLCA may be required to repay these amounts should the assets in XLAF’s investment portfolio prove insufficient or should XLAF otherwise fail to perform its obligations thereunder. As of December 31, 2007 and 2006, the aggregate face amount of such investment agreements guaranteed by XLCA was $4.0 billion and $3.9 billion, respectively. To date, XLCA has not had any claim with respect to these investment agreements nor has it been required to collateralize any of these investment agreements. Although XLAF is a wholly-owned subsidiary of XL Capital, XL Capital is not contractually obligated to support XLAF under its obligations under the investment agreements. XL Capital has, however, communicated to XLCA and publicly disclosed its intent to settle all such liabilities by the end of March 2008. Accordingly, XLCA does not expect to incur any claims under its insurance of XLAF’s investment agreements. As of February 29, 2008, the remaining aggregate face amount outstanding of such investment agreements was approximately $2.0 billion.
The Insurance Act provides that the statutory assets of an insurer must exceed its statutory liabilities by an amount greater than the prescribed minimum solvency margin.
During the year ended December 31, 2007, the Company awarded 329,825 shares under the Plan in the form of stock options and 718,096 shares under the Plan in the form of restricted stock. In addition, the Company awarded 7,600 restricted stock units under the plan to directors, of which 1,900 relate to directors who, as officers of XL Capital, pledged such options to XL Capital. The Awards vest as set forth in the applicable Award agreements, and the requisite service period is equivalent to the vesting period. The Awards contain certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability.
On February 26, 2008, the Company adopted a retention program for certain senior executive officers of the Company (the “Retention Program”). Participants in the Retention Program are entitled to receive a fixed retention payment in quarterly installments in 2008. Participants must be employed on the last day of the quarter to be eligible for a quarterly payment. However, if a participant is terminated without cause, he or she will receive a retention payment for the quarter in which the termination occurs. The aggregate amount of retention bonuses payable under the Retention Program is approximately $1.9 million.