The 2004 Atlantic hurricane season resulted in four insured hurricane losses aggregating to the largest seasonal loss in history and had a substantial impact on the results of the Company for 2004. The following table sets forth the impact of Hurricanes Frances, Charley, Ivan and Jeanne as well as the Tsunami in South Asia on the Company’s statement of operations for 2004 by operating segment. The Company estimated net hurricane losses and loss expenses incurred of $516.6 million net of reinsurance recoverables, based on preliminary reports and estimates of loss and damage. In addition, the Company incurred net losses and loss expenses of $74.6 million in 2004 as a result of the earthquake and the subsequent Tsunami that struck South Asia on December 26, 2004. The bulk of expected claims relate to property exposure, with personal accident and marine exposures also affected.
Net investment income was $995 million in 2004 as compared to $779.6 million in 2003 due primarily to a higher investment base. The investment portfolio increased due to positive operating cash flows and growth in structured and spread balances, combined with capital raising activities. In addition, net realized gains produced by the investment portfolio and the equity earnings from the Company’s affiliates also contributed positively to the year. Net realized gains on investments were $246.5 million in 2004 compared to $120.2 million in 2003. Net income from investment affiliates was $124.0 million in 2004 compared to $119.2 million in 2003. Net income from operating affiliates (including insurance, financial and investment manager affiliates) was $147.4 million in 2004 compared to $8.9 million in 2003. Earnings from operating affiliates during 2004 included $102.1 million of income in connection with the sales of Admiral Group Ltd and Pareto Partners and its affiliated companies.
5. Other than temporary declines in investments in 2003 and 2002.
Case reserves for the Company’s general operations are established by management based on amounts reported from insureds or ceding companies and consultation with legal counsel, and represent the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company. The method of establishing case reserves for reported claims differs among the Company’s operations.
The Company is not aware that there is a generally accepted model to perform the reserve range analysis described above and other models may also be employed to develop ranges.
Written premiums on excess of loss contracts are earned in accordance with the loss occurring period defined within the treaty; normally 12 months following inception of the contract. Written premiums on proportional contracts are earned over the risk periods of the underlying policies issues and renewed, normally 24 months. For both excess of loss and proportional contracts, the earned premium is recognized ratably over the earning period, namely 12 - 24 months. The portion of the premium related to the unexpired portion of the policy at the end of any reporting period is reflected in unearned premiums.
The Company’s business is conducted on a global basis where several of its subsidiaries operate in foreign currencies which are the base currency of that entity. Under U.S. GAAP, revenues and expenses of those operations are translated into the U.S. dollar at average exchange rates during the year and assets and liabilities at exchange rates at the end of the year. In the three years ended December 31, 2004 with the decline in value of the U.S. dollar against several currencies, including U.K. sterling, Swiss franc and the Euro, this has resulted in revenues and expenses translated into higher U.S. dollar values. This should be considered when making period to period comparisons.
During 2004, net prior year reserves across the reinsurance segment developed favorably by $24 million. Releases of $144 million in the property, aviation, marine and other lines of business were partially offset by strengthening of casualty and accident and health reserves amounting to approximately $122 million. Property catastrophe and property other reserve releases totaled approximately $101 million net related primarily to the 2002 and 2003 underwriting years where loss experience has been exceptionally good for the property line. The strengthening of casualty reserves totaled $77 million and related most significantly to professional liability reserves which were strengthened
3. Third quarter of 2002 - one U.K. portfolio of approximately $762.7 million in net premiums earned and related claims and policy benefits.
In 2003, net realized gains on investments were $120.2 million which included $344.8 million of gross realized losses on fixed income and $162.5 million of gross realized losses on equity securities. Gross realized losses in 2003 included $130.7 million of provisions for declines in fair value considered to be other than temporary. The general economy in the United States and the investment markets improved in 2003 relative to 2002.
These consolidated financial statements include the accounts of the Company and all of its subsidiaries. These consolidated financial statements have been prepared in accordance with U.S. GAAP (“GAAP”). The results include the consolidation of XL Re Europe, accounted for as a subsidiary effective January 1, 2002, described in Note 5(a). In addition, the results also include the acquired certain Winterthur International operations, effective July 1, 2001, under the purchase method of accounting, described in Note 5. All significant intercompany accounts and transactions have been eliminated. Certain amounts in 2003 and 2002 have been reclassified to conform to the current year presentation.
Management believes that the reserves for unpaid losses and loss expenses are sufficient to cover losses that fall within coverages assumed by the Company. However, there can be no assurance that losses will not exceed the Company’s total reserves. The methodology of estimating loss reserves is periodically reviewed to ensure that the assumptions made continue to be appropriate and any adjustments resulting there-from are reflected in income of the year in which the adjustments are made.
Fair values of investments and derivatives are based on published market values if available, estimates of fair values of similar issues or estimates of fair values determined by the Company. See Notes 2, 6 and 15 for further information.
EITF Issue No. 02-14, “Whether an Investor Should Apply the Equity Method of Accounting to Investments Other than Common Stock if the Investor Has the Ability to Exercise Significant Influence Over the Operating and Financial Policies of the Investee” (“EITF 02-14”), addresses the issue as to whether the equity method of accounting applies when an investor does not have an investment in voting common stock of an investee but exercises significant influence through other means (such as convertible debt, preferred equity securities, options, warrants and interests in unincorporated entities). In July 2004, the EITF reached a consensus that investors should apply the equity method when they have an investment in either common stock or “in-substance common stock.” The consensus reached in EITF 02-14 was effective for reporting periods beginning after September 15, 2004. The adoption of EITF 02-14 did not have a material effect on the Company’s financial condition or results of operations.
The Company is organized into three underwriting segments-insurance, reinsurance, and financial products and services-in addition to a corporate segment that includes the investment and financing operations of the Company. General, life and annuity, and financial operations are disclosed separately within each segment. General operations include property and casualty lines of business.
The total amount of other than temporary declines in value in 2004 related to $4.1 million on fixed income securities, $1.9 million on equity securities and $0.4 million on other investments. Of the decline in value of fixed income and equity securities considered to be other than temporary in 2004, approximately 50% related to investments in the airlines sector.
The Company has three facilities available for the issue of letters of credit collateralized against the Company’s investment portfolio with a value of $1.3 billion at December 31, 2004 and $467.0 million at December 31, 2003. At December 31, 2004 and 2003, approximately $198.5 million and $234.4 million, respectively, of letters of credit were issued and outstanding under these facilities.
During 2004, the Company renewed a $200 million unsecured bilateral letter of credit facility that was fully utilized throughout 2004 and at December 31, 2004.
The 6.5% Guaranteed Senior Notes indentures contains a cross default provision. In general, in the event that the Company defaults in the payment of indebtedness in the amount of $50.0 million or more, an event of default would be triggered under both the 6.5% Guaranteed Senior Notes indentures.
The Company holds warrants in conjunction with certain of its other investments. These warrants are recorded at fair value based on quoted market prices.
Included in unpaid loss and loss expenses recoverable at December 31, 2004 is an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $1.45 billion, related to certain contractual arrangements with the sale and purchase agreement, as amended (“SPA”) relating to the Company’s acquisition of Winterthur International in July 2001. The Seller is currently rated “A-” by S&P. The Seller provides the Company with post-closing protection determined as of June 30, 2004 with respect to, among other things, adverse development
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each. Holders of Class A ordinary shares are entitled to one vote for each share. In June 2000, the Company’s Class B ordinary shares were converted into Class A ordinary shares on a one-for-one basis. All ordinary shares in issue at December 31, 2004 are Class A ordinary shares.
The Employee Share Purchase Plan (the “ESPP”) was approved by the shareholders of the Company on May 10, 2002. The ESPP is administered by a committee which consists of members of the Compensation Committee of the Company’s Board of Directors. The ESPP has two offering periods a year. The first period commenced on July 1, 2002. All employees of the Company and its designated participating subsidiaries, are eligible to participate in the ESPP provided they have been employed at least one month prior to the start of the offering period and they do not hold more than 5% of the Company’s total stock, including stock acquired in the current period. Employees can invest up to 20% of their total monthly cash compensation towards the purchase of the Company’s shares up to a total market value (measured on the first day of the offering period) of U.S. $25,000. The total number of shares purchased in any offering period cannot exceed 1,000 shares. Employees who enroll in the ESPP may purchase the Company’s shares at a 15% discount on the lesser of the market price at the beginning or at the end of the six month offering period. Once purchased, employees can sell or transfer their shares to someone else’s name only during an Open Trading Window. Participants in the ESPP are eligible to receive dividends on the Company’s shares. A total of 1,255,000 ordinary shares may be issued under the ESPP. The number of share issued during the years ended December 31, 2004 and 2003 were 167,890 and 66,848, respectively.
Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. Management is required to determine if there is sufficient positive evidence to conclude that it is more likely than not that the deferred tax asset attributable to its U.S. group net operating losses would be utilized within a reasonable period. Management has reviewed historical taxable income and future taxable income projections for the U.S. group and has determined that in its judgment, the net operating losses will more likely than not be realized as reductions of future taxable income within a reasonable period. Specifically with regard to the U.S. group, management has determined that the projected U.S. consolidated income will be sufficient to utilize the net operating losses of approximately $248 million within a reasonable period. Management will continue to evaluate income generated in future periods by the U.S. group in determining the reasonableness of its position. If management determines that future income generated by the U.S. group is insufficient to cause the realization of the net operating
losses within a reasonable period, a valuation allowance would be required for the U.S. portion of the net deferred tax asset, in the amount of $240 million.
Required statutory capital and surplus represents the minimum regulatory requirements for licensing without considering Risk-Based Capital (“RBC”) standards. The 100% RBC level for principle U.S. operating subsidiaries was $569 million and $546 million at December 31, 2004 and 2003 respectively.
$77.0 million at December 31, 2003. As a result, these subsidiaries are similarly unable to currently make a dividend distribution under the insurance law of their respective states of domicile without obtaining prior approval from the domicile insurance department, which include Delaware, New York and North Dakota. At December 31, 2004 and 2003, XL Insurance Company Limited (previously known as Winterthur International Insurance Company Limited) had a statutory earned deficit and is restricted from making a dividend distribution at this time under U.K. Company law.