The Company has grown through acquisitions and development of new business opportunities. Acquisitions included Global Capital Re in 1997, Mid Ocean Limited in 1998, ECS, Inc. and NAC Re Corp. in 1999, Winterthur International in 2001 and Le Mans Ré in 2002. All acquisitions have supported the Company’s strategic plan to develop a global platform in insurance and reinsurance. The Company competes as an integrated global business with more than 4,000 employees in 28 countries.
The property and casualty insurance and reinsurance markets have historically been cyclical, meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable to the Company (a “hard market”) and there have been periods where premium rates decline and policy terms and conditions are less favorable to the Company (a “soft market”). Market conditons are driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events. Management’s goal is to build long-term shareholder value by capitalizing on current opportunities and managing through any cyclical downturns by reducing its property and casualty book of business and exposures if and when rates deteriorate to unprofitable levels. As part of its long-term strategy, the Company also looks to its Life Operations segment to provide a diversified stream of earnings that are not directly tied to the property and casualty cycle.
The Company earns its revenue primarily from net premiums written and earned. In 2005, downward pressure on rates across most non-catastrophe exposed lines continued throughout the year although the impact of the 2004 storm season, the backdrop of continued emergence of adverse development related to the market of the late 1990s and concerns about reinsurer financial strength, all served to reinforce a sense of discipline in the market.
During 2007, most lines of business within the Reinsurance segment experienced pricing erosion, increased retentions by cedants and competitive pressures in the form of other reinsurers, capital markets, and local governments. In addition, the Company continued to focus on its stated intention of defending rate adequacy in the reinsurance market and maintaining underwriting discipline. Within U.S. catastrophe exposed property lines of business, rates decreased approximately 5 to 10% off prior highs for wind exposure while rates for U.S. earthquake remained flat to down 5%. For non-U.S. non-catastrophe property lines of business, increased competition also led to price reductions of approximately 10 to 15%. Ocean marine pricing rates fell by approximately 10% except on programs that had experienced adverse claims. In addition, casualty pricing trends in the Reinsurance segment grew following those of the Insurance segment with an overall deterioration in rates and pressures on terms and conditions. Within the aviation market, rate reductions in the region of 5 to 10% continued to be experienced, although the declines experienced were less than those in the primary insurance market.
The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Reinsurance segment for the last three years ended December 31:
Going forward, management intends to maximize the Company’s ability to achieve profitable growth by focusing on leveraging the Company’s operational platforms and building out the Company’s capabilities, teams and product offerings in its chosen markets. Such markets include excess & surplus, private company D&O, fine art and specie, U.S. term life reinsurance and other lines and regions where management believes positive market indicators exist. The following sets forth potential trends relevant to the Company’s property and casualty operations in 2008:
In the Reinsurance segment, initial indications based on January 1, 2008 renewals point to a decline in premium rates across most major lines of business, as market conditions continue to soften and the reinsurance industry continues to experience pricing erosion, increased competitive pressures and increased retentions by cedants. Consistent with 2007, renewals and new business in 2008 continue to be assessed against internal hurdle rates with a continued focus on underwriting discipline. U.S. catastrophe exposed property lines have experienced rate declines of approximately 10% to 15%, while rates for non-U.S. catastrophe exposed property lines of business have dropped by up to 10%. Other property lines of business have seen rates decrease by 10% to 15%. Ocean marine pricing rates remain flat to down 5%, while rates within the aviation market have decreased by up to 10%. Casualty pricing trends in the reinsurance market have experienced deterioration in rates of up to 15%. However, rate changes on business actually bound in this line of business have decreased between 10 to 15%.
The Company seeks to generate revenue from investment activities through returns on its investment portfolio. The Company’s current investment strategy seeks to support the liabilities arising from the operations of the Company, generate investment income and build book value over the longer term.
In 2007, the Company’s net investment income increased as a result of an increase in the overall size of the investment portfolio combined with higher investment yields. However, net realized losses and impairments totaled $603.3 million during 2007 of which $385.1 million related to sub-prime and mortgage related structured assets held throughout the portfolios and primarily represented other-than-temporary impairments on securities with sub-prime non-agency collateral, second liens, ABS collateralized debt obligations (“CDOs”) with sub-prime collateral as well as Alt-A mortgage collateral holdings. In addition, net pre-tax unrealized loss position on available for sale assets deteriorated by $772.1 million in 2007 primarily as a result of the impact on fixed income securities of the deterioration of global corporate and structured credit spreads during 2007, partially offset by the impact of declining government rates in the U.S. and the U.K. as well as losses realized.
The increase in the size of the investment portfolio resulted from positive cash flows from operations and positive net cash flow from the Company’s financing activities. Higher investment yields on the Company’s investment portfolio were due primarily to the full 2007 financial year impact of the higher interest rates experienced in the U.S., U.K. and Euro-zone, during the latter part of 2006 and the beginning part of 2007. The benchmark 5-year treasury fell from 4.69% to 3.44%, and the 30-year treasury fell from 4.81% to 4.45%. Interest rates also decreased in the U.K., where the yield on the benchmark 5-year Gilt fell from 5.06% to 4.41%. In the Euro-zone, the yield on the benchmark 5-year German Bund rose slightly from 3.92% to 4.12%.
The Company expects stable net investment income from its property and casualty operations in 2008. The average asset base and yields are both expected to be stable relative to current levels.
The Company’s profitability in any given period is based upon its premium and investment revenues as noted above, less net losses incurred and expenses. Net losses incurred are based upon claims paid and changes to unpaid loss reserves. Unpaid loss reserves are estimated by the Company and include both reported loss reserves and reserves for losses incurred but not reported, or IBNR. The Company’s positive underwriting results for 2007 and 2006 were partly a result of the lack of significant catastrophe events occurring throughout these years as well as net favorable development of prior year reserves, in various lines of business within the Company’s Insurance and Reinsurance segments. This net favorable development was partially offset by the continuing increase in current period loss ratios in each of 2006 and 2007. These increases reflect the impact of the softening rate environment as well as higher levels of underlying attritional losses in those years. The Company’s results for 2005 were significantly impacted by the unprecedented insured hurricane losses during the 2005 Atlantic hurricane season, the charge related to the conclusion of the independent actuarial process with Winterthur Swiss Insurance Company (“the Winterthur Decision”) and adverse development of prior year loss reserves in both insurance professional lines and reinsurance casualty lines. In 2008, claims activity within the D&O and E&O insurance markets overall, are expected to rise as a result of an increase in class action lawsuits filed against public companies due to market losses and related stock price depreciation associated with the sub-prime mortgage and credit crisis in the U.S. Management actively monitors its potential exposure to such events and gives due consideration to emerging claim trends in determining its loss reserve requirements at each quarter end. For further analysis of this exposure, see “Results of Operations” below.
Net investment income relating to property and casualty operations does not include the net investment income related to the net results from structured products.
Fully diluted book value per ordinary share represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. The Company believes that fully diluted book value per ordinary share is a financial measure important to investors and other interested parties who benefit from having a consistent basis for comparison with other companies within the industry. However, this measure may not be comparable to similarly titled measures used by companies either outside or inside of the insurance industry.
Certain lines of business and transactions previously reported under the Financial Lines segment have been reclassified and reported under the Insurance, Reinsurance and Corporate (that includes the general investment and financing operations of the Company) segments based on the nature of the underlying business.
One way that the Company evaluates the performance of its insurance and reinsurance operations is the underwriting profit or loss. The Company does not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned and fee income, less net losses incurred and expenses related to underwriting activities, plus unrealized foreign exchange gains and losses on underwriting balances. As noted above, the Company’s strong property and casualty underwriting profit for 2007 and 2006 were partly a result of the lack of significant catastrophe events occuring throughout these years and net favorable prior year loss development. The Company’s underwriting loss in 2005 was negatively impacted by net losses incurred from catastrophic events, the results of the Winterthur Decision and adverse development of prior year loss reserves. Any changes to loss reserves affect the calculation of underwriting profit or loss but most often do not directly affect the Company’s cash flow in the same period. See further discussion below.
The combined ratio for property and casualty operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s general insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss. The Company’s combined ratio for the year ended December 31, 2007 was lower than the previous year, primarily as a result of a lower loss and loss expenses ratio partially offset by a higher underwriting expense ratio. The lower loss and loss expense ratio has resulted mainly from higher net favorable prior year development in the year ended December 31, 2007 as compared to the same period in 2006. The increased underwriting expense ratio has been driven largely by increased compensation costs and continued pricing pressures that have resulted in less premium earned. The Company’s improved combined ratio in 2006 as compared to 2005 was primarily due to the lack of significant catastrophe events in 2006 relative to 2005 in which significant losses were incurred following Hurricanes Katrina, Rita and Wilma.
and financing activities impacted book value per ordinary share, including the Company’s share repurchase activity throughout 2007 which decreased book value per ordinary share, as the price paid for such shares was at a premium to book value; however, this was partially offset by the issuance of Class A ordinary shares upon maturity of the purchase contracts associated with the 6.5% Equity Security Units (the “6.5% Units”), as the ordinary shares were issued at a premium to book value.
As noted above, fully diluted book value per ordinary share represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. Fully diluted book value per ordinary share decreased by $2.72 during the year ended December 31, 2007 as a result of the factors noted above and is generally consistent with the decrease in basic book value per ordinary share as the impact of in-the-money stock options at December 31, 2007 is negligible as a result of the reduction in market price of the Company’s ordinary shares in late 2007.
The impact due to the Company’s investment in and relationships with SCA;
Reduction in insured losses from natural catastrophes during 2007 and 2006 as compared to 2005;
The Company’s growing invested asset base and higher net investment income.
1. Impact of the Company’s investment in and relationships with SCA
The financial guarantees issued by SCA are generally guarantees of payments under financial guarantee insurance policies or credit default swaps. The financial guarantee business model generally provides for a guarantee of payment of interest and principal over the defined expected life of a transaction, with no acceleration or need for collateralization by the guarantor in the case of any weakness or default by the underlying obligor. These characteristics reduce the need for liquidity within the financial guarantor in case of underlying deterioration in the guaranteed transaction, since the calendar of payments remains as set in the original transaction. As a general matter, the obligations of XLCA under credit default swaps issued in connection with their business accrue in a similar manner, except in events of default, however, they do not qualify for the financial guarantee insurance scope exception under FAS 133 and, therefore, are reported at fair value, with changes in fair value included in earnings. Under most of the credit default swap contracts insured by XLCA, it would be an event of default if XLCA should become insolvent. If there were an event of default, the holders of these credit default swap contracts would have the right to terminate the swaps and to obtain a termination payment from XLCA, based on the market value of the swaps at the time of termination.
The Company records 46.9% of the net income of SCA as earnings from operating affiliates. Subsequent to the secondary sale of shares in June 2007 and the associated deconsolidation of financial results, the Company reports such earnings on a one quarter lag due to the limited availability and timing of SCA’s final audited financial results. Management expects to continue this practice on the same basis with appropriate consideration given by disclosure or otherwise to the effects of any known intervening events that materially affect the Company’s financial position or results of operations.
Management has done extensive analysis of SCA’s financial guarantee portfolio to evaluate the exposures and underlying possible losses arising from recent credit market turbulence. Given management’s view of the potential scale of SCA’s estimated losses along with the uncertainty facing the entire financial guarantee industry, the Company has reduced the reported value of its investment in SCA to nil from the reported equity method value of $669.8 million as at September 30, 2007. Recent market developments with respect to monoline industry and industry analyst reports have indicated that the fair value of any investment in the financial guarantee sector has very uncertain value at this point in time. Subsequent to December 31, 2007, SCA was downgraded by several rating agencies, which significantly limits SCA’s ability to write new business. In addition, the shares in SCA held by the Company are unregistered and thus illiquid. Based on the nature of the Company’s investment in SCA and the resultant limitations on any future business models, management believes that the fair value of the Company’s investment in SCA is substantially less than the traded market value at December 31, 2007 of $3.89 per share. Management believe this decline in value is other than temporary.
Based on all of the above factors along with the Company’s extensive analysis of the relevant exposures, the Company has concluded that no losses are expected under these guarantees and accordingly no loss reserves have been recorded. Recently published loss estimates by S&P appear to support this view.
The following tables present the net par outstanding related to the guarantees provided by the Company at December 31, 2007 by credit quality and broad sector allocation:
Where appropriate, further details of each of the items noted above can be found in the related section of See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, Notes 3 and 8 to the Consolidated Financial Statements, “Security Capital Assurance” and “Investments in Affiliates.”
2. Impact of credit market movements on the Company’s investment portfolio
In 2007, financial market conditions were extremely challenging as the global credit crisis that begun in July 2007 continued to adversely impact global fixed income markets. Elements which contributed to this included continued weakness in the U.S. housing market and increased mortgage delinquencies, investor anxiety over recessionary pressures, rating agency downgrades of various structured products, unresolved issues with structured investment vehicles and a serious dislocation in the interbank market. All of these elements led to significant declines in mortgage and structured credit prices. Continued declines in government rates did little to alleviate the concerns in either residential mortgage markets or the short-term funding market during the fourth quarter of 2007. These elements were the primary drivers behind the $603.3 million in net realized losses on investments reported for the year ended December 31, 2007.
Realized losses and impairments in the topical asset exposed portfolios totaled $385.1 million during the year ended December 31, 2007 and represented a combination of losses on sub-prime non-agency securities, second liens, ABS CDOs with sub-prime collateral as well as Alt-A mortgage exposures. These losses and impairments were principally concentrated in 2005, 2006, and 2007 vintage securities.
The Company’s sub-prime and Alt-A exposures remain primarily highly rated, have strong underlying loan characteristics and are supported by adequate subordination levels. The remaining net unrealized losses are primarily in higher rated securities, and the Company believes these losses are a result of technical spread widening rather than any fundamental deterioration. Based on the Company’s stress testing, even in an extreme scenario, management believes principal impairments to these remaining pools is unlikely.
As at December 31, 2007, approximately 14.1% of the asset and mortgage-backed holdings were classifed as part of the Company’s exposure to topical assets. This represented approximately 5.2% of the total fixed income portfolio and 29.0% of the total net unrealized loss position. Of the topical asset securities, approximately 99% are rated as investment grade. All portfolio holdings, including those with sub-prime exposure, are reviewed as part of the ongoing other-than-temporary-impairment monitoring process. The Company continues to actively monitor its exposures, and to the extent market disruptions continue, including but not limited to residential mortgages, the Company’s financial position could be negatively impacted.
See Item 8, Note 10 to the Consolidated Financial Statements and see further discussion under “Critical Accounting Policies and Estimates”.
Overall, 2007 and 2006 experienced a limited number of natural catastrophes as compared to 2005; however, 2007 did result in an increase in overall natural catastrophe activity and insured losses as compared to 2006. In 2007, six hurricanes formed in the Atlantic region including two Category 5 hurricanes, while other natural catastrophes in 2007 included European windstorms Kyrill and Per/Hanno, California wildfires, floods in the U.K. and Mexico, the Peruvian earthquake and five hurricanes in the Eastern Pacific region. In 2006, there were only five hurricanes in the Atlantic region and more importantly there was no significant insured damage for those hurricanes that did make landfall.
During 2005, as a result of Hurricanes Katrina, Rita, and other catstrophes, the Company incurred losses, net of reinsurance recoveries, of $1.27 billion, $357.9 million, $247.1 million and $96.0 million, respectively, as at year end December 31, 2005. Net reserves established for these events developed adversely in 2006 by $119.4 million and were partially offset by additional loss sensitive premium received.
The Company has in place an Enterprise Risk Management committee (the “ERM Committee”) to facilitate the management of firm-wide risks that the Company faces across all of its businesses. The ERM Committee is comprised of the most senior risk takers and managers of the Company. The objective of the ERM Committee is to make recommendations to the Executive Management Board on overall risk aggregates, correlated risk as well as risk allocation in order to proactively manage enterprise risks.
The Company believes that effective talent management and succession planning processes are key to the long-term success of the Company. As such, the Company has implemented various development programs and succession planning efforts across the Company. The Company’s development programs include the global development program for its high potential junior employees, the performance development program for its managers and team leaders, and the leadership development program for its senior managers. Succession planning efforts include identifying and monitoring the various talent pools within the Company to match the future needs and long-term strategy of the Company. In addition and as noted above, the Board of Directors in late 2007 implemented a CEO succession plan including the authorization of a Succession Committee to lead the new CEO selection process for the Company.
In the second quarter of 2007, the Company announced a refined strategy that will focus on its insurance, reinsurance and life reinsurance operations. Thus, the Company no longer pursues diversification outside of its insurance and reinsurance platforms unless it meets high hurdle rates and is connected to its business. Accordingly, the following product lines or transactions previously managed by and reported via the Financial Lines Segment are now, depending on the nature of the business written, managed as part of the Insurance and Reinsurance segments and reported therewith: (i) structured indemnity products managed through the Company’s financial solutions operations (“XLFS”), (ii) political risk products, (iii) weather and energy management products, and (iv) legacy financial guarantee business. The earnings on the Company’s investment in Primus Guaranty Ltd. (“Primus”) and other financial operating affiliates as well as the results of certain structured finance products are reported as part of the Corporate segment that includes the general investment and financing operations of the Company. The Company has exited and placed into run-off the political risk insurance business, but remains in the political risk reinsurance business. In addition, the GIC and funding agreement businesses are now reported separately within the Other Financial Lines segment.
Evaluation of the impact of recent credit market volatility on core underwriting operations
to these credit related issues in the core property and casualty insurance and reinsurance business, in particular the Insurance segment professional lines portfolio exposures through D&O and E&O policies.
Management has also reviewed the potential sub-prime exposure in the reinsurance segment which is more limited and again, potential exposure was factored into establishing the year-end reserve position.
On February 4, 2008, the Company announced that Celia R. Brown was appointed to the Company’s Executive Management Board. Ms. Brown will remain in her current role, Head of Global Human Resources and Corporate Relations, which oversees the Company’s Human Resources, Marketing, Global Communications, Public Relations and Corporate Social Responsibility functions.
The Company is committed to achieving competitive differentiation through the strategic alignment of initiatives that will deliver flexible and robust technology platforms to the Company and its customers. The focal point of this strategy is the development and enhancement of a reliable infrastructure. Senior management continues to devote significant attention to the development of multiple programs and initiatives across all aspects of the Company that will improve operational efficiency, standardize processes and optimize costs.
For example, the Insurance segment has begun a multiple year operational transformation program that will result in enhanced product differentiation and business process standardization aligned with the segment’s growth strategy. In addition, the Company continues to invest in the information technology infrastructure and efficient process design within the Reinsurance segment and its operations center based in India. The Company has implemented a standardized common desktop computing environment for all its professionals globally. Finally, a financial reporting and controls program has implemented a standardized global financial platform along with consistently integrated business and financial processes. This program which has lead a transformation of the Company’s financial architecture, also lead to the implementation of a new chart of accounts and technical architecture centered around an upgraded general ledger system. As a result of this program, the Company has benefited from a stronger control environment and greater flexibility in its ability to analyze financial information.
The success of the above mentioned initiatives requires management focus and the investment of the Company’s resources to achieve more consistent service delivery through the implementation of a reliable infrastructure.
In the normal course of business, the Company is exposed to foreign exchange fluctuations on various items on its financial statements, in particular investments, future policy benefit reserves and unpaid losses and loss expenses. This exposure also exists on certain inter-company balances, which are eliminated for consolidation purposes. The Company attempts to manage this economic exposure through matching foreign currency denominated liabilities with foreign currency denominated assets. While unrealized foreign exchange gains and losses on underwriting balances are reported in earnings, the offsetting unrealized gains and losses on invested assets are recorded as a separate component of shareholders’ equity, to the extent that the asset currency does not match that entity’s functional currency. This results in an accounting mismatch, that will result in foreign exchange gains or loss in the consolidated statements of income depending on the movement in certain currencies. In order to improve administrative efficiencies as well as to address this accounting imbalance, the Company formed several branches with Euro and U.K. Sterling functional currencies during 2006 and 2007. Management continues to focus on attempting to limit this type of exposure in the future.
Other significant accounting policies are nevertheless important to an understanding of the Company’s Consolidated Financial Statements. Policies such as those related to revenue recognition, financial instruments and consolidation require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. See Item 8, Note 2 to the Consolidated Financial Statements, “Significant Accounting Policies.”
As noted above, case reserves for the Company’s reinsurance operations are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the Company’s estimated ultimate cost of a loss. In addition to information received from ceding companies on reported claims, the Company also utilizes information on the pattern of ceding company loss reporting and loss settlements from previous catastrophic events in order to estimate the Company’s ultimate liability related to these hurricane loss events. Commercial catastrophe model analyses and zonal aggregate exposures are utilized to assess potential client loss before and after an event. Initial cedant loss reports are generally obtained shortly after a catastrophic event, with subsequent updates received as new information becomes available. The Company actively requests loss updates from cedants periodically for the first year following an event. The Company’s claim settlement processes also incorporate an update to the total loss reserve at the time a claim payment is made to a ceding company.
becomes available. Any such adjustments are accounted for as changes in estimates and are reflected in the results of operations in the period in which they are made.
Over time, as a greater number of claims are reported, actuarial estimates of IBNR are based on the BF and loss development techniques. The BF method utilizes actual loss data and the expected patterns of loss emergence, combined with an initial expectation of ultimate losses to determine an estimate of ultimate losses. This method may be appropriate when there is limited actual loss data and a relatively less stable pattern of loss emergence. The chain ladder method utilizes actual loss and expected patterns of loss emergence to determine an estimate of ultimate losses that is independent of the initial expectation of ultimate losses. This method may be appropriate when there is a relatively stable pattern of loss emergence and a relatively larger number of reported claims. Multiple estimates of ultimate losses using a variety of actuarial methods are calculated for many, but not all, of the Company’s (150+) classes of business for each year of loss experience. The Company’s actuaries look at each class and determine the most appropriate point estimate based on the characteristics of the particular class and other relevant factors, such as historical ultimate loss ratios, the presence of individual large losses, and known occurrences that have not yet resulted in reported losses. Once the Company’s actuaries make their determination of the most appropriate point estimate for each class, this information is aggregated and presented to management for review and approval.
Discontinued asbestos and long-tail environment business had been previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to its acquisition by the Company. As at December 31, 2007, total gross unpaid losses and loss expenses in respect of this business represented less than 1% of unpaid losses and loss expenses.
Property and catastrophe IBNR includes event specific reserves for losses that the Company’s insureds and cedants have informed us they expect to incur but have not yet had reported known claims.
The following table shows the recorded estimate and the high and low ends of the range of the Company’s net unpaid losses and loss expenses (excluding financial guarantee reserves related to reinsurance agreements with SCA that are recorded within “Net loss from operating affiliates”) for each of the lines of business noted above at December 31, 2007:
Property and catastrophe IBNR includes event specific reserves for losses that the Company’s insureds and cedants have informed it they expect to incur but have not yet had reported known claims.
Actual development of recorded reserves as of December 31, 2006 during 2007 was within the estimated reserve range.
Case basis reserves on financial guarantee reinsurance assumed are generally established upon notification from SCA who is the Company’s principal ceding company. Case basis reserves are established by SCA and the Company’s proportionate share of these reserves are reported on a quarterly basis. Based on our evaluation of the loss activity reported to the Company on a quarterly basis, it may, in management’s judgment, establish case reserves greater than those reported by SCA. This information is recorded into the Company’s records upon receipt of these statements. Due to the timing of the receipts of such statements from SCA, the Company may at times need to rely on its independent assessment based on previously reported data.
Case basis reserves on financial guarantee insurance business written by SCA and reinsured by the Company with respect to a specific policy or contract are established upon receipt of a claim notice or when management determines that (i) a claim is probable in the future based on credit events that have occurred and (ii) the amount of the ultimate loss that the Company will incur can be reasonably estimated. As specific case basis reserves are established, the Company considers whether any changes are required to the assumptions underlying the calculation of unallocated reserves (which are discussed below) as a result of such activity. Management would only expect such changes to occur in limited instances, such as economic events generating significant loss activity across a broad cross-section of the portfolio. Management has not viewed the Company’s case basis reserve and unallocated reserve activity to date to warrant a change in the unallocated reserves. While material case basis reserves were established in 2007, these reserves were concentrated in certain sectors of the financial guarantee portfolio and were associated with unprecedented credit-market events. As such, these events did not alter the Company’s perspective of the expected loss ratio associated with the remainder of the portfolio and the required level of unallocated reserves.
The amount of the case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that the Company expects to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are determined using cash flow or similar models to estimate the net present value of the anticipated shortfall between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from the proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries. A number of quantitative and qualitative factors are considered when determining or assessing, in management’s judgment, the need for a case basis reserve. These factors may include the creditworthiness of the underlying issuer of the insured obligation, whether the obligation is secured or unsecured, the projected cash flow or market value of any assets that collateralize or secure the insured obligation, and the historical and projected loss rates on such assets. Other factors that may affect the actual ultimate loss include the state of the economy, changes in interest rates, rates of inflation and the salvage values of specific collateral. Case basis reserves are generally discounted at a rate reflecting the yield on the Company’s investment portfolio during the period the case basis reserve is established. The Company believes this yield is an appropriate rate to discount the Company’s reserves because it reflects the rate of return on the assets supporting such business. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an upfront basis, the Company continues to record premium earnings on such policy over its remaining life, unless it has recorded a full limit loss with respect to such policy, in which case the remaining deferred premium revenue relating thereto is immediately reflected in earnings. When a case basis reserve is established for a guaranteed obligation whose premium is paid on an installment basis, those premiums, if expected to be received prospectively, are considered a form of recovery netted against the loss reserves and are no longer earned as premium revenue.
Management believes that its reserves are adequate to cover the Company’s expected ultimate losses. However, due to the inherent uncertainties of estimating reserves for loss and loss adjustment expenses, actual experience may differ from the estimates reflected in the Company’s consolidated financial statements, and the differences may be material. Differences exist within the
The recognition of unpaid losses and loss expenses recoverable requires two key judgments. The first judgment involves the Company’s estimation of the amount of gross IBNR to be ceded to reinsurers. Ceded IBNR is generally developed as part of the Company’s loss reserving process and consequently, its estimation is subject to similar risks and uncertainties as the estimation of gross IBNR (see “Critical Accounting Policies and Estimates - Unpaid losses and loss expenses and unpaid loss and loss expense recoverable”). The second judgment involves the Company’s estimate of the amount of the reinsurance recoverable balance that the Company will ultimately be unable to recover from related reinsurers due to insolvency, contractual dispute, or for other reasons. Amounts estimated to be uncollectible are reflected in a bad debt provision that reduces the reinsurance recoverable balance and shareholders’ equity. Changes in the bad debt provision are reflected in net income. See “Financial Condition and Liquidity” and Item 8, Note 11 to the Consolidated Financial Statements, “Reinsurance”, for further information.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $5.8 billion and $5.7 billion at December 31, 2007 and 2006, respectively. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile. A 0.1% decrease in the investment yield assumption would result in approximately a $45 million increase in the value of future claims related to annuity portfolio reinsurance.
The Company also provides reinsurance of term assurance and critical illness policies written in the U.K. and Ireland. The future policy benefit reserves for these contracts amounted to approximately $242 million and $135 million at December 31, 2007 and 2006, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience. The provisions for adverse deviation in these reserves amounted to approximately $22m and $12m at December 31, 2007 and 2006, respectively.
The liabilities relate to in-force blocks of business and to treaties accepting new business, comprising underlying insurance policies that provide mainly lump sum benefits if the policyholder dies or becomes sick. For term assurance, the liabilities are therefore driven by the rates of mortality and for critical illness cover, the liabilities are driven predominantly by the rates at which policyholders become sick, where sickness is defined by the treaty conditions (i.e., the morbidity rates). A 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $2.1 million, and a 1% increase in the morbidity rate would increase the value of future claims by approximately $2.0 million.
The term assurance and critical illness treaties have been written using a variety of structures, some of which incur acquisition costs during an initial period. For such treaties, a deferred acquisition cost (“DAC”) asset has been established and an increase in future lapse rates could impact the recoverability of such costs from future premiums. The recoverability will also be influenced by the impact of lapses on future claims. An increase in the annual lapse rates by 1% could lead to a 5%-10% reduction in future margins available for amortizing the DAC asset.
The liabilities relate to in-force blocks of business, which are comprised of underlying insurance policies that provide mainly lump sum benefits if the policyholder dies. The liabilities are therefore driven by the rates of mortality, and a 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $9 million. The liabilities are also affected by lapse experience, and a 1% decrease in lapse rates relative to the reserving assumption would increase the reserve by approximately $1.4 million. Following a review of mortality and lapse experience, the locked-in assumptions were reviewed during 2007 and it was determined that the assumptions should be revised. The overall effect of the revised assumptions was a reduction in income of $25.4 million. No changes to the locked-in assumptions were made in 2006.
For further information see Item 8, Note 13 to the Consolidated Financial Statements, “Future Policy Benefit Reserves.”
estimates of rates of return which would be required by market participants to assume the risks in the current market environment;
the market perception of risk associated with asset classes referenced in the CDS contracts;
prices of guarantees issued in the retail market or commutations of contracts it has executed in proximity to the measurement date.
SCA management considers all available relevant evidence in forming its best estimate of the fair value of the CDSs, as new information becomes available they may consider new or different factors than those listed above and change its estimates in the future.
In forming the best estimate of the fair value of the CDS contracts subsequent to June 30, 2007, however, SCA management concluded that limited reliance could be placed on price indices because events and conditions in the credit markets associated with subprime mortgage collateral and corporate loans resulted in limited or no transaction activity in many financial instruments since June 30, 2007 (including CDOs) of high grade ABS, CLOs, RMBS, and CDOs of CDOs, causing financial institutions which publish the indices that SCA management historically relied upon to estimate the fair value of credit derivatives either to refrain from updating such indices or base changes in the indices partly on judgments in regard to estimated price levels and not actual executed trades. In addition, evidence suggested that the limited price information available in the marketplace in regard to such instruments was influenced by trades resulting from margin calls and liquidity issues that are not part of the risks associated with SCA’s business model or CDS contracts. As a result of that discussed above, the fair value of credit defaults swaps subsequent to June 30, 2007 were estimated by SCA management as follows:
in instances where current market indices were reliable and available, the estimate of fair value was based on applying the percentage change in the applicable credit price index or indices applicable to the assets referenced in the CDS by the present value of the remaining expected future premiums to be received under the contract, and
the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized in the period such determination is made.
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, changing information, market conditions generally and assessing value relative to other comparable securities. Day-to-day management of the Company’s investment portfolio is outsourced to third party investment managers. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available for sale.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other than temporary decline. Management reviews any significant sales of securities for a loss to determine if such sale impacts the assertion with respect to the intent and ability to hold to recovery. For further details on management’s assessment of other than temporary impairments, see Item 8, Note 7 to the Consolidated Financial Statements, “Investments”. However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its ability to hold such securities is supported by positive and sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment obligations arising from its underwriting operations without selling such investments. In this regard, cash flow from operating activities was $2.2 billion and $2.4 billion in 2007 and 2006, respectively.
The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company had capitalized net operating tax losses of $396.9 million and $334.0 million against which a valuation allowance of $204.4 million and $198.9 million at December 31, 2007 and 2006, respectively, was established. The Company had capitalized realized and unrealized capital losses of approximately $404 million and $74 million, respectively, against which a valuation allowance of approximately $167 million at December 31, 2007 was established. The deferral of benefits from tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts, the character of income and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax affected.
The Company utilizes variable interest entities both directly and indirectly in the ordinary course of business. The Company must assess consolidation of variable interest entities based on whether the Company is the primary beneficiary of the entity. The company that absorbs a majority of the expected losses or residual rewards of the entity is deemed to be the primary beneficiary and is therefore required to consolidate the entity. The determination of expected losses and expected residual returns requires the Company to estimate the expected cash flows of the entities and measure the expected variability of these cash flows. The use of different assumptions to determine the expected cash flows and variability could affect the Company’s determination of the primary beneficiary. The assumptions used to determine the expected cash flows depend on the type of structure and the nature of the Company’s variable interest. The Company has made assumptions primarily regarding default rates, the timing of defaults and recovery rates to estimate these expected cash flows of the variable interest entities that it utilizes. See Item 8, Note 17 to the Consolidated Financial Statements “Variable Interest Entities”, for further information.
The Company writes business on both an excess of loss and proportional basis. In the case of excess of loss contracts, the subject written premium is generally outlined within the treaty and the Company receives a minimum and/or deposit premium on a quarterly basis which is normally followed by an adjustment premium based on the ultimate subject premium for the contract. The Company estimates the premium written on the basis of the expected subject premium and regularly reviews this against actual quarterly statements to revise the estimate based on the information provided by the cedant.
Reinstatement premiums are recognized at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are fully earned when recognized. Accrual of reinstatement premiums is based on the Company’s estimate of loss and loss adjustment expense reserves, which involves management judgment as described below.
Reinsurance operations by their nature add further complications in that generally the ultimate premium due under a specific contract will not be known at the time the contract is entered into. As a result, more judgment and ongoing monitoring is required to establish premiums written and earned in the Company’s reinsurance operations.
The amount of premiums receivable related to the Company’s reinsurance operations amounted to $2.0 billion as at December 31, 2007.
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Management reviews the premiums receivable balance at least quarterly and provides a provision for amounts deemed to be uncollectible. The Company recorded a provision for uncollectible premiums receivable at December 31, 2007 of $18.6 million.
To better align the Company’s operating and reporting structure with its current strategy and subsequent to the secondary offering of SCA’s common shares on June 6, 2007, the Company revised its segment structure during the second quarter of 2007. Depending on the nature of the business written, the following product lines or transactions previously managed by and reported as part of the Financial Lines segment, are now managed as part of the Insurance and Reinsurance segments and reported therewith: (i) structured indemnity products managed through the Company’s financial solutions operations (“XLFS”), (ii) political risk products, (iii) weather and energy management products, and (iv) legacy financial guarantee business. Subsequent to June 6, 2007, SCA is no longer a consolidated subsidiary or a separate operating segment of the Company and its remaining investment in SCA is accounted for using the equity method of accounting. However, historical consolidated results of the Company include the separately reported net income of SCA through to June 6, 2007. The earnings on the Company’s investment in Primus and other financial operating affiliates as well as the results of certain structured finance products are reported as part of the Corporate segment that includes the general investment and financing operations of the Company. In addition, the guaranteed investment contract and funding agreement businesses are now reported separately within the Other Financial Lines segment.
Net premiums earned decreased by 1.0% in the year ended December 31, 2007 compared with the year ended 2006 and reflected the earn-out of overall lower net premiums written in both 2006 and 2007.
Fee income and other decreased in 2007 as compared to 2006 and increased in 2006 as compared to 2005 primarily due to a favorable legal settlement recorded in 2006 in relation to a U.K. contract as well as certain foreign exchange adjustments recorded in 2006.
The following table presents the ratios for the Insurance segment for each of the last three years ended December 31:
The loss and loss expense ratio noted above includes net losses incurred for both the current year and any favorable or adverse prior year development of loss and loss expense reserves held at the beginning of the year.
Within the Insurance segment, the loss and loss expense ratio for the year ended December 31, 2006 decreased compared with the year ended December 31, 2005, primarily as a result of the absence of large natural catastrophe events and the unfavorable result of Winterthur Decision during 2005. Excluding the impact of these events, the loss ratio in 2005 was 66.8%. The relative decrease in 2006 relates to net favorable prior year reserve releases. Net favorable prior year reserve development for the year ended 2006 was $13.2 million. This overall favorable development included reserve releases of $94.4 million in property lines and $91.1 million in casualty lines, partially offset by $96.5 million, $46.5 million and $29.3 million of prior year adverse development in certain professional, marine and other lines of business, respectively. The gross prior year favorable development for the Insurance segment was $371.4 million. This gross favorable development exceeds the corresponding net development as gross reported losses in casualty have developed more favorably than net losses. Lower gross reported loss amounts reflect reductions in several large recoverable losses on older years and an absence of new large losses, with consequent reductions to reinsurance recoveries.
During 2005, total net adverse prior year development within the Insurance Segment was $1.02 billion of which $834.2 million resulted from the negative outcome of the Winterthur Decision. The remaining $186.0 million was comprised of net adverse prior year development of $259.7 million in professional lines and $34.7 million within other specialty lines including runoff and discontinued business partially offset by releases of $108.4 million primarily in European casualty business.
The increase in the underwriting expense ratio in the year ended December 31, 2007, compared to the same period in 2006 was due to an increase in the operating expense ratio of 1.2 points (16.6% as compared to 15.4%), partially offset by a decrease in the acquisition expense ratio of 0.2 points (11.8% as compared to 12.0%). The increase in the operating expense ratio was due primarily to higher compensation costs associated with higher head count and corporate allocations, and was partially offset by adjustments booked in 2007 relating to previously accrued regulatory costs. The decrease in the acquisition expense ratio resulted primarily from an increase in outward reinsurance profit commissions as well as favorable prior year premium adjustments. Offsetting these decreases was the impact of a reduction in certain ceded brokerage costs in 2006.
Foreign exchange losses in the years ended December 31, 2007 and 2006, and foreign exchange gains in the year ended December 31, 2005, were due primarily to the change in the value of the U.S. dollar against certain European currencies including the U.K. Sterling and the Euro on certain inter-company balances.
Net results from structured insurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Results from these contracts for the year ended December 31, 2007, decreased compared to the same period in 2006 due to an unfavorable accretion adjustment recorded in 2007 based on changes in expected cash flows and the accelerated earnings recorded in 2006 resulting from a commutation. Offsetting these decreases was higher net investment income as a result of higher yields and overall larger investment asset balances. Results for these contracts for the year ended December 31, 2006, decreased as compared to the year ended December 31, 2005, due to a favorable accretion adjustment recorded in 2005 based on changes in expected cash flows, partially offset by higher yields in 2006 and from the accelerated earnings in 2006 resulting from a commutation.
million, respectively, recorded in 2005. These decreases were partially offset by a change in accrual methodology and both written and ceded premiums adjustments for certain U.S. property programs in 2006. On a net premiums written basis, the decrease was also attributable to the catastrophe quota share reinsurance treaty with Cyrus Re. In addition, as part of the Company’s aggregate risk reduction initiatives, there was a net reduction in catastrophe exposure and a restructuring of the Company’s marine and energy exposures.
The loss and loss expense ratio includes net losses incurred for both the current year and any favorable or adverse prior year development of loss reserves held at the beginning of the year.
Within the Reinsurance segment, the decrease in the loss and loss expense ratio in the year ended December 31, 2006, compared to the same period in 2005, primarily reflected the lack of large natural catastrophe events such as those that occurred
3. Second and fourth quarters of 2005 - A large U.K. immediate annuity portfolio contract bound representing $1.8 billion in net premiums earned and two Irish immediate annuity portfolios which totaled $96.2 million.
Net premiums earned in the year ended December 31, 2007 increased 8.4% as compared to the same period in 2006. This increase was consistent with the increase in gross and net premiums written as described above. Net premiums earned in the year ended December 31, 2006 decreased by 72.0% compared to the same period in 2005, mainly as a result of the assumption of the large U.K immediate annuity portfolio contract noted above.
Changes in claims and policy benefit reserves were generally consistent with movements in gross and net premiums written but also included the movement in policy benefit reserves related to other contracts (such as tranches of immediate annuity portfolios) where investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract. Claims and policy benefit reserves increased by $81.4 million or 10.1% in the year ended December 31, 2007 as compared to the same period in 2006 mainly as a result of growth in the underlying block of term assurance and critical illness business increasing losses by $65.2 million, unfavorable foreign exchange rate movements of $52.8 million, a loss recognition adjustment of $25.4 million relating to certain novated blocks of U.S.-based term life mortality reinsurance business, offset by lower losses relating to single premium immediate annuity business of $62.0 million from fewer single premium portfolio contracts bound during the year.
Net investment income is included in the calculation of contribution from Life Operations, as it relates to income earned on portfolios of separately identified and managed life investment assets and other allocated assets. Net investment income increased by $38.3 million or 10.9% in 2007 as compared to 2006, primarily as a result of favorable foreign exchange rate movements of $23.9 million and increases in the average size of investment asset balances. Net investment income increased by $53.5 million or 17.9% in 2006 as compared to 2005, primarily as a result of an increase in the average size of investment asset balances, improved yields and favorable foreign exchange rate movements.
While not reported within the contribution from the Other Financial Lines segment, it should be noted that approximately $370.7 million of the reported realized losses on investments for 2007 related to portfolios associated with funding agreements and guaranteed investment contracts.
months of 2006. In addition, operating expenses increased due to higher compensation expenses and the corporate costs associated with being a public company on a stand alone basis.
The Company records the income related to alternative fund affiliates on a one month lag and the private investment fund affiliates on a three month lag in order for the Company to meet the accelerated filing deadlines.
Net investment income related to property and casualty operations increased in 2007 as compared to 2006 due primarily to a higher investment base and increases in the yield of the portfolio. The market yield to maturity on the fixed income portfolio was 5.8% at December 31, 2007, as compared to 5.2% at December 31, 2006. The increase was primarily due to the full 2007 financial year impact of the higher interest rates experienced in the U.S., U.K. and Euro-zone, during the latter part of 2006 and the beginning part of 2007.
At December 31, 2007 and 2006, total investments, cash and cash equivalents, accrued investment income and net payable for investments purchased were $43.7 billion and $44.7 billion, respectively. This decrease of $0.9 billion was primarily due to the mark-to-market effect as a result of the challenging credit markets as well as impact of the Company’s financing activities, and was partially offset by positive cash flow from operations of $2.2 billion. The annualized effective yield of the total investment portfolio (excluding non-recurring items) was 5.6% for 2007 as compared to 5.1% for 2006, a 0.5% increase. The increase in the effective yield of the total investment portfolio was primarily due to investment duration being lengthened in early 2007 prior to declining interest rates in the U.S. and the U.K.
Net income from investment fund affiliates includes earnings from the Company’s investments in closed-end investment funds and partnerships and similar vehicles that are equity accounted. Net income from investment fund affiliates increased in 2007 as compared to 2006 due primarily to exceptional results in the alternative portfolio and as a result of a higher investment asset base. Net income from investment fund affiliates increased in 2006 as compared to 2005 primarily due to a strong result in private investment portfolios due to a series of positive liquidity events and fair value adjustments, as well as good returns on the alternative portfolios.
In addition, derivative losses for the year ended December 31, 2007 include a mark-to-market loss of $37.0 million in the third quarter with respect to a total return swap on the capital notes of a SIV impacted by the challenging credit markets. During the fourth quarter, the Company terminated the swap, recognized an additional $3.9 million mark-to-market loss and took delivery of the underlying asset. The asset was subsequently written off to nil resulting in a realized loss on investments of $57.3 million.
The Company manages its investment grade fixed income securities using an asset/liability management framework. Due to the unique nature of the underlying liabilities, customized benchmarks are used to measure investment performance and comparison to standard market indices is not meaningful. Investment performance is not monitored for certain assets primarily consisting of operating cash and special regulatory deposits. The following is a summary of the investment portfolio returns for the years ended December 31, 2007 and 2006 of the asset/liability portfolio and risk asset portfolios:
Performance on the alternative portfolio reflects the twelve months ended November 30, 2007 and 2006, respectively.
In 2006, net realized losses on investments were $116.5 million which includes $390.4 million of gross realized losses on fixed income and $88.5 million of gross realized losses on equity securities. Gross realized losses in 2006 included $151.4 million of provisions for declines in fair value considered to be other than temporary. In 2005, net realized gains on investments were $241.9 million which includes $250.8 million of gross realized losses on fixed income and $54.1 million of gross realized losses on equity securities. Gross realized losses in 2005 included $53.2 million of provisions for declines in fair value considered to be other than temporary.
Net realized and unrealized losses on investment derivatives for 2007 resulted primarily from losses associated with the capital notes of a SIV as noted above. For a further discussion see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” and “- Liquidity and Capital Resources.”
Investment manager affiliate income increased in 2007 as compared to 2006 mainly due to strong results generated from certain global equity and mortgage specialist investment manager affiliates, partially offset by the write-off of the Company’s investment in a manager that managed a series of structured investment vehicles and conduits.
Net income from other strategic operating affiliates increased in 2007 as compared to 2006, primarily as a result of strong results from an insurance affiliate which writes largely U.S. homeowners insurance and the Company’s Brazilian joint venture ITAU´ XL.
In 2006, the increase in net income from operating affiliates relative to 2005 was primarily due to the gain on sale of the FrontPoint Partners LLC, an investment mangement affiliate, of $41.7 million. The results also include continued strong performance by the Company’s investment management affiliates driven by strong growth in assets managed by these minority-owned managers.
Income tax expense for the year ended December 31, 2007 increased as compared to the same period in 2006, and increased from 2006 as compared to 2005, principally from an improvement in the profitability of the Company’s U.S. and European property and casualty operations in those respective years. The Company’s effective tax rate for the year ended December 31, 2007 increased from that in 2006 due primarily to non-deductible asset impairment charges recorded in Bermuda, the U.S. and the U.K. The Company’s effective tax rate for the year ended December 31, 2006 decreased slightly from that in 2005 due to $30.0 million of tax benefits associated with corrections in the year to reserves ceded to its Bermuda reinsurance entities. In addition, the Company recorded a tax charge in 2006 of $6.0 million in connection with the IPO of SCA.
Minority interest expense in 2007 related primarily to the 37% ownership interest in SCA common shares held by the public prior to the secondary offering of SCA common shares on June 6, 2007, while minority interest expense in 2006 related primarily to the 37% ownership interest in SCA following the initial public offering in August 2006 as well as the minority interest ownership in preferred shares of XL Financial Assurance (“XLFA”). In addition, included in each of the respective years presented is minority interest in the common shares of XL International (Bermuda) Ltd.
The Company reviews on a regular basis its issuer concentration, credit quality and compliance with established guidelines. At December 31, 2007 and 2006, the average credit quality of the Company’s total fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) was “AA.” At December 31, 2007 approximately 53.4% of the fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) was rated “AAA” by one or more of the principal ratings agencies. Approximately 2.3% was below investment grade or not rated.
The information shown below about the unrealized losses on the Company’s investments at December 31, 2007 and 2006, concerns the potential effect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary.
The following is an analysis of how long each of those investment securities with an unrealized loss at December 31, 2007 and 2006 had been in a continual unrealized loss position:
At December 31, 2007, the total gross unrealized losses represented approximately 7,600 fixed income securities out of a total of approximately 17,100 fixed income securities (representing fixed maturities, short-term investments, cash and cash equivalents and net payable for investments purchased) and approximately 300 equity securities out of a total of approximately 1,000. At December 31, 2006, the total gross unrealized losses represented approximately 9,700 fixed income securities out of a total of approximately 17,300 and approximately 200 equity securities out of a total of approximately 1,300.
Factors considered in determining that additional other-than-temporary impairment charges were not warranted include; managements’ consideration of current and near term liquidity needs, an evaluation of the factors and time necessary for recovery, and the results of on-going retrospective reviews of security sales and the basis for such sales. Securities in an unrealized loss position at December 31, 2007 are comprised of sub-prime first liens and Alt-A asset backed securities, CDOs with insignificant residential mortgage collateral, unrealized foreign exchange losses on US dollar assets held in foreign subsidiaries with little underlying value impairment and unrealized losses on investments supporting long-term liabilities which have no history of significant sales at a loss. Following a detailed review of the Company’s underlying sub-prime residential and related mortgage exposures (“topical assets”) described above, as well as a consideration of the broader structured credit market, the Company has concluded that the remaining investments in these asset classes have decreased in value due to technical spreads widening and broader market sentiment, rather than fundamental collateral deterioration. Topical assets are held primarily in the Company’s Other Financial Lines segment GIC portfolios and management has put in place a strategy to monitor and address the liquidity needs associated with these portfolios with the intent of holding the positions to recovery. The fact that the underlying securities cash flows continue to be in accordance with their contractual terms, combined with manager evaluations of the fundamentals supporting the underlying positions, have lead management to conclude that the values of the investments for which it reports unrealized losses as at December 31, 2007 are not other than temporarily impaired, as management currently has the intent and ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in market value.
At December 31, 2007 and 2006, the following table sets forth the maturity profile of the fixed income securities that were in a gross unrealized loss position:
As a holding company, the Company’s assets consist primarily of its investments in subsidiaries and affiliates, and the Company’s future cash flows depend upon the availability of dividends or other statutorily permissible payments from its subsidiaries and affiliates. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries in which the Company operates, including, among others, Bermuda, the United States, Ireland, Switzerland, the United Kingdom, and those of the Society of Lloyd’s and certain contractual provisions. See Item 8, Note 25 to the Consolidated Financial Statements, “Statutory Financial Data”, for further discussion. No assurance can be given that the Company or its subsidiaries will be permitted to pay dividends in the future.
As an insurance company, one of the Company’s principal responsibilities to its clients is to ensure that the Company has ready access to funds to settle large unforeseen claims. The Company would generally expect that positive cash flow from operations (underwriting activities and investment income) will be sufficient to cover cash outflows under most future loss scenarios. However, there is a possibility that unforeseen demands could be placed on the Company due to unforeseen claims activity. Potential events causing such a liquidity strain could be several significant catastrophes occurring in a relatively short period of time or large scale uncollectible reinsurance recoverables on paid losses (as a result of coverage disputes, reinsurers’ credit problems or decreases in the value of collateral supporting reinsurance recoverables). Additional strain on liquidity could occur if the investments sold to fund loss payments were sold at depressed prices. Because each subsidiary focuses on a more limited number of specific product lines than is collectively available from the consolidated group of companies, the mix of business tends to be less diverse at the subsidiary level. As a result, the probability of a liquidity strain, as described above, may be greater for individual subsidiaries than when liquidity is assessed on a consolidated basis. If such a liquidity strain were to occur in a subsidiary, the Company may be required to contribute capital to the particular subsidiary and/or curtail dividends from the subsidiary to support holding company operations.
Cash flows related to financing activities include ordinary and preferred share related transactions, the payment of dividends, the issue or repayment of debt and deposit liability transactions. In 2007, the Company repurchased approximately $1.1 billion of ordinary shares through its share repurchase programs and issued approximately $825.0 million of ordinary shares in connection with the maturity of the purchase contracts associated with the 6.5% Units. In addition, the Company issued Series E preference ordinary shares for $1 billion and redeemed both its Series A and Series B preference ordinary shares for $230.0 million and $287.5 million, respectively. With regards to debt transactions in 2007, the Company purchased and retired the 2009 Senior Notes for $825.0 million in connection with the 6.5% Units and issued the 2027 Senior Notes for gross proceeds of approximately $324.4 million. In 2007, dividends paid were $274.0 million for ordinary shares and $69.5 million for preferred shares. In 2007, the Company paid out $360.0 million of net cash relating to deposit liability contracts. See below for further discussion surrounding recent and potential payments associated with GICs guaranteed by subsidiaries of SCA. In 2006, the Company received $342.2 million related to the sale of a portion of its interest in SCA through a primary offering.
In addition, in the years ended December 31, 2006 and 2005, the Company executed a number of debt and equity transactions which affected the cash flow from financing activities described below in “Capital Resources,” below.
Letters of credit and other forms of collateral that are required by the Company’s operating companies that are “non-admitted” under U.S. state insurance regulations. The Company also uses letters of credit to support its operations at Lloyd’s.
In December 2005, the Company issued 38.9 million ordinary shares at a price of $65.0 per share to support capital requirements subsequent to the 2005 Atlantic hurricane losses and the loss related to the conclusion of the Winterthur Decision. The net proceeds from this issuance were $2.4 billion. See Item 8, Note 20, to the Consolidated Financial Statements, “Share Capital.”
At December 31, 2007, banks and investors provided the Company and its subsidiaries with $4.0 billion of debt capacity, of which $2.9 billion was utilized by the Company. These facilities consist of:
Senior Unsecured Notes of approximately $2.9 billion. These notes require the Company to pay a fixed rate of interest during their lives. At December 31, 2007, there were six outstanding issues of senior unsecured notes:
$600 million senior notes due September 2014, with a fixed coupon of 5.25%. The security is publicly traded. The notes were issued in two tranches of $300 million aggregate principal amount each - one tranche at 99.432% and the other at 98.419%. Aggregate gross proceeds were $593.6 million. Related expenses of the offering amounted to $4 million.
The 2010 and 2012 5-year revolving credit facilities share a $1.0 billion revolving credit sublimit.
In addition to funded debt transactions, the Company has entered into contingent capital transactions. No up-front proceeds were received by the Company under these transactions, however, in the event that the associated irrevocable put option agreements are exercised,
proceeds previously raised from investors from the issuance of pass-through trust securities would be received in return for the issuance of preferred shares.
The Company reviews current and projected collateral requirements on a regular basis, as well as new sources of collateral. Management’s objective is to maintain an excess amount of collateral sources over expected uses. The Company also reviews its liquidity needs on a regular basis.
On February 21, 2007, the Company amended the letter of credit facility supporting its syndicates at Lloyd’s of London by reducing the aggregate commitments from the participating banks from £500 million to £450 million. On November 14, 2007, the Company renewed this facility for a further two years.
On June 22, 2007, three facilities expired - a $2 billion three-year unsecured credit and letter of credit facility, a $500 million 364-day letter of credit facility, and a bilateral 364-day $100 million credit and letter of credit facility.
On June 22, 2007, the Company closed a new $4 billion unsecured revolving credit and letter of credit facility. The new facility has a term of five years. The facility is available in the form of revolving credit in the amount of $1 billion (such limit is shared with the Company’s other syndicated revolving credit facility that closed in June 2005) and in the form of letters of credit in the aggregate amount of $4 billion.
In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”). These facilities were increased to $500.0 million in June 2003. The proceeds of advances under the Credit Facilities were used to fund a trust account (“Trust”) to collateralize the reinsurance obligations of the Company under an intercompany quota share reinsurance agreement. The Company could have faced additional obligations under the Credit Facilities prior to the stated maturity of February 25, 2008, if certain events had occurred, including, but not limited to the Company’s insolvency, withdrawal of assets from the Regulation 114 trust by the ceding company, the downgrade of the Company’s credit ratings below certain specified levels, or the failure of the agent to have a first priority perfected security interest in the collateral posted by the Company. The issued securities and the Company’s repayment obligations were recorded as a net balance on the Company’s balance sheet because the Company had a contractual legal right of offset. In February 2008, the Company terminated this arrangement, resulting in a repayment of $500.0 million and termination of the Trust.
In general, all of the Company’s bank facilities, indentures and other documents relating to the Company’s outstanding indebtedness, including the Credit Facilities discussed above (collectively, the “Company’s Debt Documents”), contain cross default provisions to each other and the Company’s Debt Documents contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of the Company’s insurance and reinsurance operating subsidiaries and the level of secured indebtedness in the future. In addition, generally each of the Company’s Debt Documents provide for an event of default in the event of a change of control of the Company or some events involving bankruptcy, insolvency or reorganization of the Company. The Company’s credit facilities and the 6.58% Guaranteed Senior Notes also contain minimum consolidated net worth covenants.
Under the Company’s 2-year Lloyd’s and five-year U.S. credit facilities placement notes described above, in the event that the XL Capital Group, XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur. In January 2008, A.M. Best Company, Inc. (“A.M. Best”) revised the financial strength rating of the Company’s leading property and casualty operating subsidiaries to “A” from “A+” and affirmed them with a ‘stable’ outlook. The downgrade by A.M. Best was primarily due to their concerns regarding the Company’s historic earnings volatility.
Under the Company’s ten-year private placement notes described above, in the event that the Company fails to maintain a financial strength rating of at least “A” from A.M. Best or XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A” from S&P, an event of default would occur. The Company and its subsidiaries currently has an “A+” (stable) rating from S&P and an “A” (stable) rating from A.M. Best.
The unpaid loss and loss expenses were $23,207,694 on the Company’s Consolidated Balance Sheet at December 31, 2007. The timing and amounts of actual claims payments related to these P&C and financial guarantee reserves vary based on many factors including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claims payments could differ materially from the Company’s estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors effecting potential payment patterns of reserves for actual and potential claims related the Company’s different lines of business see “Critical Accounting Policies and Estimates” above. Certain lines of business written by the Company, such as excess casualty, have loss experience characterized as low frequency and high severity. This may result in significant variability in loss payment patterns and, therefore, may impact the related asset/liability investment management process. In order to be in a position, if necessary, to make these payments, the Company’s liquidity requirements are supported by having revolving lines of credit facilities available to the Company and significant reinsurance programs, in addition to the Company’s general high grade fixed income investment portfolio.
See Item 8, Note 2 to the Consolidated Financial Statements, “Significant Accounting Policies”, for a discussion on recent accounting pronouncements.
severity of claims and loss activity, including as a result of natural or man-made catastrophic events, than the Company’s underwriting, reserving or investment practices anticipate based on historical experience or industry data; (x) developments in the world’s financial and capital markets that adversely affect the performance of the Company’s investments and the Company’s access to such markets including, but not limited to further market developments relating to sub-prime and residential mortgages (xi) the potential impact on the Company from government-mandated insurance coverage for acts of terrorism; (xii) the potential impact of variable interest entities or other off-balance sheet arrangements on the Company; (xiii) developments in bankruptcy proceedings or other developments related to bankruptcies of companies insofar as they affect property and casualty insurance and reinsurance coverages or claims that the Company may have as a counterparty; (xiv) availability of borrowings and letters of credit under the Company’s credit facilities; (xv) changes in regulation or tax laws applicable to the Company or its subsidiaries, brokers or customers; (xvi) acceptance of the Company’s products and services, including new products and services; (xvii) changes in the availability, cost or quality of reinsurance; (xviii) changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers; (xix) loss of key personnel; (xx) the effects of mergers, acquisitions and divestitures; (xxi) changes in ratings, rating agency policies or practices; (xxii) changes in accounting policies or practices or the application thereof; (xxiii) legislative or regulatory developments; (xxiv) changes in general economic conditions, including inflation, foreign currency exchange rates and other factors; (xxv) the effects of business disruption or economic contraction due to war, terrorism or other hostilities; and (xxvi) the other factors set forth in the Company’s other documents on file with the United States Securities and Exchange Commission (the “SEC”). The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.
XL Capital Ltd, through its operating subsidiaries (the “Company” or “XL”), is a leading provider of insurance and reinsurance coverages to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis. The Company and its various subsidiaries operate globally in 28 countries, through its four business segments: Insurance, Reinsurance, Life Operations, and Other Financial lines. These segments are further discussed in Note 4 to the Consolidated Financial Statements, “Segment Information.”
On June 6, 2007, the Company completed the sale of a portion of SCA’s common shares owned by the Company through a secondary offering and thereby reduced its ownership of SCA’s outstanding common shares from approximately 63% to approximately 46%. Accordingly, SCA is no longer a consolidated subsidiary or operating segment of the Company and the Company accounts for its remaining investment in SCA using the equity method of accounting. For further information see Note 3 to the Consolidated Financial Statements, “Security Capital Assurance (“SCA”).”
brokers and cedants and, with respect to SCA, certain underwriting costs and are deferred and amortized over the period that the premiums are earned. Acquisition costs are shown net of commissions earned on reinsurance ceded. Future earned premiums, the anticipated losses and other costs (and in the case of a premium deficiency, investment income) related to those premiums, are also considered in determining the level of acquisition costs to be deferred.
The Company’s direct use of investment related derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, reference rates or a combination of these factors. The Company uses investment derivatives to manage duration and foreign currency exposure for its investment portfolio as well as to add value to the investment portfolio through replicating permitted investments, provided the use of such investments is incorporated into the overall portfolio evaluation.
The Company also uses investment derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. All derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); a hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract.
Changes in the the fair value of a derivative that is designated and qualifies as a fair value hedge, along with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk, are recorded in current period earnings (through “net realized and unrealized gains and losses on derivative instruments”) with any differences between the net change in fair value of the derivative and the hedged item representing the hedge ineffectiveness. Periodic derivative net coupon settlements are recorded in net investment income with the exception of hedges of Company issued debt which are recorded in interest expense.
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed minimum income benefit (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated and recorded at fair value with changes in fair value recognized in earnings.
Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as investments in affiliates on the Company’s balance sheet and are accounted for under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in its results for the period as well as its portion of movements in certain investee’s shareholder equity balances. When financial statements of the affiliate are not available on a timely basis to record the Company’s share of income or loss for the same reporting periods as the Company, the most recent available financial statements are used. This lag in reporting is applied consistently until timely information becomes available. Significant influence is deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or greater in closed end funds, limited partnerships, LLC’s or similar investment vehicles. Significant influence is considered for other strategic investments on a case-by-case basis.
The Company accounts for its other investments which do not have readily determinable market values at estimated fair value as it has no significant influence over these entities. Fair values for other investments, principally other direct equity investments, investment funds and limited partnerships, are based on the net asset value or financial statements provided by the investment manager. The net unrealized appreciation or depreciation on investments, net of tax, is included in “accumulated other comprehensive income (loss).” Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
Intangible assets with an indefinite life and goodwill are not amortized. The Company continues to review the carrying value of goodwill related to all of its investments for any impairment as of June 30 and records an adjustment, if any, in the third quarter each year. If it is determined that an impairment exists, the Company adjusts the carrying value of goodwill to fair value. The impairment charge is recorded in income in the period in which it is determined. See Note 5, “Goodwill and Other Intangible Assets” for further information.
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.
The deposit accretion rate is the rate of return required to fund expected future payment obligations (this is equivalent to the “best estimate” of future cash flows), which are determined actuarially based upon the nature of the underlying indemnifiable losses. Accretion of the liability is recorded as interest expense. The Company periodically reassesses the estimated ultimate liability. Any changes to this liability are reflected as adjustments to interest expense to reflect the cumulative effect of the period the contract has been in force, and by an adjustment to the future accretion rate of the liability over the remaining estimated contract term.
The Company adopted the provisions of FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, on January 1, 2007. The Company did not recognize any liabilities for unrecognized tax benefits as a result of the implementation of FIN 48.
During November 2005, the FASB issued FASB Staff Position No. FAS 123(r)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The Company has elected to adopt the alternative transition method provided in this FASB Staff Position for calculating the tax effects of share-based compensation pursuant to FAS 123 (r). The alternative transition method includes a simplified method to establish the beginning balance of the additional paid-in capital pool (APIC pool) related to the tax effects of employee share-based compensation, which is available to absorb tax deficiencies which could be recognized subsequent to the adoption of FAS 123(r).
For all periods presented prior to 2006, and for all options granted prior to January 1, 2003, the Company accounted for stock option grants under the recognition and measurement principles of APB 25 and related interpretations and accordingly, recognized no compensation expense for these stock options granted to employees. The following table illustrates the effect on earnings per share for the year ended December 31, 2005 if the Company had applied the fair value recognition to all of its stock-based employee compensation:
In September 2005, the Accounting Standards Executive Committee (AcSEC) issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (“SOP 05-1”). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 was effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The Company adopted SOP 05-1 as of January 1, 2007. The application of this standard did not have a material impact on the Company’s financial condition and results of operations.
In February 2006, the FASB issued FAS 155, Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140. This standard permits fair value re-measurement of an entire hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; narrows the scope exemption applicable to interest-only strips and principal-only strips from FAS 133; clarifies that only the simplest separations of interest payments and principal payments qualify as not being subject to the requirements of FAS 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends FAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This statement is intended to require more consistent accounting that eliminates exemptions and provides a means to simplify the accounting for hybrid financial instruments. This statement was effective for all financial instruments acquired or issued after January 1, 2007. The Company has applied the fair value option to its investments in interest-only strips from the effective date of this standard. The fair value of interest only strips was $8.9 million and $17.3 million at December 31, 2007 and December 31, 2006, respectively. The application of the fair value option did not have a material impact on the Company’s financial condition and results of operations.
In December 2006, the FASB issued implementation guidance, FAS 133 Implementation Issue B40 Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets (DIG B40), which limits the circumstances in which prepayment risk within a securitized interest would be considered an embedded derivative. To facilitate transition, securitized interests issued before June 30, 2007, containing insignificant embedded derivatives are not subject to paragraph 13(b). The provisions of DIG B40 which became effective as of July 1, 2007 were adopted by the Company; however, the adoption of this provision did not have a material impact on the Company’s financial condition or results of operations.
The Company is aware of the SEC’s review of the loss reserving practices of the financial guarantee industry. The Company recognizes that there is diversity in practice among financial guarantee insurers and reinsurers with respect to their accounting policies. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60 “Accounting and Reporting by Insurance Enterprises” (“FAS 60”) does not specifically address the unique characteristics of financial guarantee insurance contracts. Consequently, the accounting principles applied by the industry have evolved over time and incorporate the concepts of both short-duration and long-duration contracts accounting under the provisions of FAS 60 and other accounting literature such as FAS 5 and EITF 85-20. On April 18, 2007, the FASB issued its anticipated exposure draft, “Accounting for Financial Guarantee Insurance Contracts, an interpretation of FAS 60”, which provides guidance for the accounting for financial guarantee insurance contracts under which it considers claims liability recognition, premium recognition, and the related amortization of deferred policy acquisition costs. This exposure draft was issued with a comment deadline of June 18, 2007. The Company has reviewed the exposure draft and will continue its loss reserving methodology as noted in Note 2 (k), until further guidance is finalized by the SEC or FASB. The Company had reserves for financial guarantee insurance contracts of $427.4 million and $262.7 million at December 31, 2007 and December 31, 2006, respectively.
In June 2007, the Accounting Standards Executive Committee of the AICPA issued Statement of Position 07-1, “Clarification of the Scope of the Audit and Accounting Guide “Investment Companies” and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (“SOP 07-1”). SOP 07-1 provides guidance for determining whether an entity meets the definition of an investment company for financial reporting purposes and therefore should apply investment company accounting. In addition, the standard provides guidance to determine whether the specialized industry accounting principles for investment companies should be retained in the consolidated financial statements of a non-investment parent company or of an investor who has the ability to exercise significant influence over the investment company and accounts for its investment under the equity method. In addition, SOP 07-1 includes certain disclosure requirements for parent companies and equity method investors in investment companies that retain investment company accounting in the parent company’s consolidated financial statements or the financial statements of an equity method investor. SOP 07-1 was expected to be effective for fiscal years beginning on or after December 15, 2007, with earlier application encouraged, however, during its October meeting the FASB agreed to issue an exposure draft that would indefinitely defer the effective date of SOP 07-1 until the FASB can reassess SOP 07-1’s provisions. SOP 07-1 is not expected to have a material impact on the Company’s financial condition and results of operations.
In December 2007, the FASB issued FAS 141(R), Business Combinations (“FAS 141(R)”). This statement retains the purchase method of accounting for acquisitions, and requires that an acquirer recognize and measure in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at their fair values as of the acquisition date. FAS 141(R) changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the expensing of acquisition-related costs as incurred, and establishes a framework for recognizing and measuring goodwill or a gain from a bargain purchase at the acquisition date. FAS 141(R) also establishes disclosure requirements to enable the evaluation of the nature and financial effects of the business combination. FAS 141(R) will be effective for interim and annual financial statements issued after January 1, 2009 and applies prospectively to business combinations for which the acquisition date is subsequent to January 1, 2009. Earlier adoption is prohibited. The Company is currently evaluating the potential impact of this guidance, which will apply only in the event of a future business combination.
In December 2007, the FASB issued FAS 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of ARB No. 51” (“FAS 160”), to establish accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. FAS 160 requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the consolidated financial statements within the equity section but separate from the company’s equity. It also requires the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified and presented on the face of the consolidated statement of income; requires any changes in ownership interest of the subsidiary be accounted for as equity transactions; and requires that when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former subsidiary and the gain or loss on the deconsolidation of the subsidiary be measured at fair value. FAS 160 will be effective for interim and annual financial statements issued after January 1, 2009. FAS 160 must be applied prospectively as of January 1, 2009, however, the presentation and disclosure standards must be applied retrospectively to all periods presented. Earlier adoption is prohibited. The Company is currently evaluating the potential impact of this guidance.
In February 2008, the FASB issued FSP FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”), which permits a one-year deferral of the application of FAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). FSP FAS 157-2 will be effective in conjunction with FAS 157 for interim and annual financial statements issued after January 1, 2008. Accordingly, the provisions of FAS 157 will not be applied to goodwill and other intangible assets held by the Company and measured annually for impairment testing purposes only.
Management has done extensive analysis of SCA’s underlying financial guarantee portfolio to evaluate the exposures and underlying possible losses arising from recent credit market turbulence. Given management’s view of the potential scale of SCA’s estimated losses along with the uncertainty facing the entire financial guarantee industry, the Company has reduced the reported value of its investment in SCA to nil from the reported equity method value of $669.8 million as at September 30, 2007. Recent market developments with respect to monoline industry and industry analyst reports have indicated that the fair value of any investment in the financial guarantor sector has very uncertain value at this point in time. Subsequent to December 31, 2007, SCA was downgraded by several rating agencies, which significantly limits SCA’s ability to write new business. In addition, the Company’s shares in SCA are unregistered and thus illiquid. Based on the nature of the Company’s investment in SCA and the resultant limitations on any future business models, management believes that the fair value of the Company’s investment in SCA is substantially less than the traded market value at December 31, 2007 of $3.89 per share. Management believe this decline in value is other than temporary.
The Company has entered into a series of service agreements under which subsidiaries of the Company provide services to SCA and its subsidiaries such as (i) information technology support, (ii) consulting and management services, (iii) actuarial, finance, legal and internal audit services, (iv) certain long-term compensation costs and (v) certain investment management services or receive certain services for a period of time after the IPO. For the period from June 6, 2007 through December 31, 2007, the Company reported net fee income under the aforementioned agreements aggregating to approximately $2.5 million.
The following tables present the net par outstanding related to the facultative reinsurance and the adverse development facultative reinsurance noted above at December 31, 2007 by credit quality and broad sector allocation:
To better align the Company’s operating and reporting structure with its current strategy and subsequent to the secondary offering of SCA’s common shares on June 6, 2007, the Company revised its segment structure during the second quarter of 2007. Depending on the nature of the business written, the following product lines or transactions previously managed by and reported as part of the Financial Lines segment, are now managed as part of the Insurance and Reinsurance segments and reported therewith: (i) structured indemnity products managed through the Company’s financial solutions operations (“XLFS”), (ii) political risk products, (iii) weather and energy management products, and (iv) legacy financial guarantee business. Subsequent to June 6, 2007, SCA was no longer a consolidated subsidiary or a separate operating segment of the Company and its remaining investment in SCA is accounted for using the equity method of accounting. However, historical consolidated results of the Company include the separately reported net income of SCA through to June 6, 2007.
Given the changes in the Company’s operating and reporting structure as described above, the Company is now organized into four operating segments: Insurance, Reinsurance, Life Operations, and Other Financial Lines - in addition to a corporate segment that includes the general investment and financing operations of the Company.
Reinsurance business written includes treaty and facultative reinsurance to primary insurers of casualty and property risks, principally: general liability; professional liability; automobile and workers’ compensation; commercial and personal property risks; specialty risks including fidelity and surety and ocean marine; property catastrophe; property excess of loss; property pro-rata; marine and energy; aviation and satellite; and various other reinsurance to insurers on a worldwide basis. In addition, the results of certain transactions structured by XLFS that are generally written on an aggregate stop loss or excess of loss basis are included within the results of the Reinsurance segment.
As noted above, as a result of the downgrades of XLCA, the Company will settle, by late March 2008, the majority of the GIC portfolio.
Net (loss) from investment and operating affiliates includes the equity earnings from the Company’s investment in SCA since June 6, 2007, reported on a one quarter lag as well losses, including OTTI, associated with this investment and losses relating to reinsurance agreements with SCA.
Net income from SCA represents consolidated earnings for the period from January 1, 2007 through to June 6, 2007, prior to a secondary offering of SCA’s common shares owned by the Company, which had the effect of reducing its ownership of SCA’s outstanding common shares from approximately 63% to approximately 46%. Subsequent to June 6, 2007, the Company accounted for its remaining investment in SCA using the equity method of accounting.
The net results from P&C structured products includes net investment income, interest expense and operating expenses of $115.2 million, $48.4 million, and $23.7 million, respectively.
The following table shows an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2007, 2006 and 2005:
The aggregate purchase price was approximately $34.1 million in cash. The final purchase price is subject to adjustment upon receipt of a closing balance sheet and the Company is in the process of obtaining third-party valuations of certain intangible assets, which are both expected to be completed during the first quarter of 2008; accordingly, both the final purchase price and its allocation are subject to refinement. Of the purchase price paid during 2007, ($1.0) million was allocated to the identifiable net liabilities assumed, with the remaining $35.1 million recorded as goodwill. GAPS results of operations were included in the Company’s income statement from the date of purchase, however, they did not have a significant impact on the Company’s results.
Under the terms of the SPA, WSIC also provided the Company with protection with respect to third party reinsurance receivables and recoverables related to the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”). Such protection was provided in the form of Sellers Retrocession Agreements and a Liquidity Facility.
The Agreement further provides for a four-year term, collateralized escrow arrangement (the “Fund”) of up to $185 million (plus interest) to protect certain subsidiaries from future nonperforming third party reinsurance related to the Winterthur Business. The Fund has been structured to align the parties’ interests by providing for any sums remaining in the Fund at the end of its term to be shared in agreed percentages.
At December 31, 2007, there were $1,069.5 million of gross unrealized losses on fixed maturities and short-term investments, and $14.9 million of gross unrealized losses on equity securities. At December 31, 2006, there were $244.1 million of gross unrealized losses on fixed maturities and short-term investments, and $5.4 million of gross unrealized losses on equity securities. At both December 31, 2007 and 2006, approximately 2.3% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. Approximately 6.4% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2007 related to securities that were below investment grade or not rated. The information shown below about the unrealized losses on the Company’s investments at December 31, 2007 concerns the potential affect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary declines.
The following is an analysis of how long each of those securities at December 31, 2007 had been in a continual unrealized loss position:
The fair values of securities on loan at December 31, 2007 and 2006 are detailed below.
When financial statements of the affiliate are not available on a timely basis to record the Company’s share of income or loss for the same reporting periods as the Company, the most recent available financial statements are used. This lag in reporting is applied consistently until timely information becomes available.
The Company has invested in certain closed end funds, certain limited partnerships, LLC’s and similar investment vehicles, including funds managed by certain of its investment manager affiliates. Collectively, these investments in funds, partnerships and other vehicles are classified as ‘investment fund affiliates’. At December 31, 2007, investments affiliates totaled $2.2 billion of which $1.8 billion was invested in the alternative investment portfolio and $0.4 billion consisted of private investments. At December 31, 2006, investment fund affiliates totaled $1.9 billion of which $1.6 billion was invested in the alternative investment portfolio and $0.3 billion consisted of private investments.
For the period from June 6, 2007 to December 31, 2007 the Company has incurred case losses of $300.0 million and $51.0 million on a net present value basis with respect to the excess of loss and facultative reinsurance agreements with SCA, respectively. In addition, the Company incurred $17.9 million in additional mark to market losses related to those underlying contracts written in derivative form. See Note 15 “Derivative Instruments” for further details on embedded credit derivatives. These losses were based on the Company’s examination of exposures under these agreements and have been recorded within “Net loss from operating affiliates” and not within property and casualty underwriting results. These amounts represent the discounted value of expected losses net of related premiums and are discounted at approximately 5%. In the case of the excess of loss cover, the recorded loss represents the discounted value of a $500 million full limit loss.
As at September 30, 2007, SCA had total assets of $2.99 billion, total liabilities of $1.35 billion, outstanding preferred share equity of $246.6 million, and common shareholders equity of $1.35 billion. For the period from June 6, 2007 to September 30, 2007 SCA had net earned premiums of $73.1 million, total revenues of $(40.4) million, and a net loss to common shareholders before minority interest of $77.4 million. For further details of the results of SCA and the Company’s related transactions see Note 3 “Security Capital Assurance.”
The Company’s other strategic operating affiliates at December 31, 2007 included investments of $53.5 million in ARX Holding Corporation and $78.1 million in ITAÚ XL Seguros Corporativos S.A., with ownership in these entities at 46.4% and 49.9%, respectively.
The Company’s investment manager affiliates include Highfields Capital Management LP, a global equity investment firm, MKP Capital Management, a fixed income investment manager, specializing in mortgage-backed securities, Stanfield Capital Partners, a credit-oriented asset management firm specializing in collateralized loan obligations, OneCapital Management Partners, a diversified alternative investment management firm, Banquo Credit Management LLP, a European-based credit asset management firm, Artemis Advisors LLC, a U.S. focused equity firm, Polar Capital Holdings plc, an investment firm offering traditional and alternative products, Cinnamon Capital Management LLP, an asset management firm that invests in the residuals of European asset backed securities, HighVista Strategies LLC, a diversified wealth management firm, and Finisterre Cayman Limited, an emerging market specialist asset management firm.
In certain investments, the carrying value is different from the share of the investee’s underlying net assets. The differences represents goodwill on acquisition or other-than-temporary impairments recorded with respect to the investment.
Income on unrated tranches of collateralized loan obligations is reflected only to the extent the Company’s principal has been fully recovered. Income on alternative investments included in other investments is realized only on ultimate sale of these investments. The Company had net unrealized gains of $78.9 million and $49.1 million, respectively, at December 31, 2007 and 2006, related to these alternative investments. In 2007 and 2006, the Company had realized gains related to the alternative investments of nil and $5.0 million, respectively.
See Note 18(b), “Commitments and Contingencies - Other Investments,” for further information regarding commitments related to other investments.
The Company regularly reviews the performance of these other investments. The Company recorded losses of $0.1 million, $15.4 million and $0.1 million in the years ended December 31, 2007, 2006 and 2005, respectively, due to other than temporary declines in values of these other investments.
(1) Does not include $351.0 million of losses incurred related to the facultative and excess of loss reinsurance of SCA. These losses are included in “Net loss from operating affiliates.”
The significant developments in prior year loss reserve year estimates for each the years indicated within the Company’s Insurance and Reinsurance segments are discussed below.
Within the Reinsurance segment, net prior year releases of $267.3 million in the year ended December 31, 2007 consisted of $188.7 million primarily in property and other short-tail lines of business and $87.4 million in casualty and other lines, was partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. Releases in the short-tail lines relate primarily to the 2005 and 2006 accident years. The casualty and other lines favorable development of $87.4 million reflects the net result of releases of $121.4 million primarily in the US and non-US casualty portfolios, partially offset by net adverse development of $13.0 million associated with the results of an external review of the Company’s asbestos and environmental reserves and $21.0 million related to a commutation of a stop loss reinsurance agreement. Favorable gross prior year development of $259.7 million was in line with the net development.
Net losses disposed in 2007 in the amount of $155.3 million represent reserves associated with the de-consolidatation of SCA following the secondary offering on June 6, 2007 of $181.4 million, partially offset by net losses acquired of $26.2 million related to a reinsurance-to-close loss portfolio transfer.
The Company’s net unpaid losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2007 and 2006, the reserve for potential non-recoveries from reinsurers was $193.1 million and $218.3 million, respectively.
Incurred but not reported losses, net of reinsurance, included in the above table was $73.1 million in 2007, $64.1 million in 2006 and $16.7 million in 2005. Unpaid losses recoverable are net of potential uncollectible amounts.
The Company utilizes reinsurance and retrocession agreements principally to increase aggregate capacity and to reduce the risk of loss on business assumed. The Company’s reinsurance and retrocession agreements provide for recovery of a portion of losses and loss expenses from reinsurers and reinsurance recoverables are recorded as assets. The Company is liable if the reinsurers are unable to satisfy their obligations under the agreements. Under its reinsurance security policy, the Company seeks to cede business to reinsurers generally rated “A” or better by Standard & Poor’s (“S&P”) or, in the case of Lloyd’s syndicates, “B+” from Moody’s Investors Service, Inc. (“Moody’s”). The Company considers reinsurers that are not rated or do not fall within the above rating categories and may grant exceptions to the Company’s general policy on a case-by-case basis.
At December 31, 2007, the total reinsurance assets of $5.5 billion included reinsurance receivables for paid losses and loss expenses of $0.8 billion and $4.7 billion with respect to the ceded reserve for losses and loss expenses, including ceded losses incurred but not reported. Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is based on specific contract provisions, the collectibility of such amounts requires significant estimation by management. The majority of the balance the Company has accrued as recoverable will not be due for collection until sometime in the future. Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and while they may continue to acknowledge their contractual obligation to do so, they may not have the financial resources or willingness to fully meet their obligation to the Company.
The Company uses a default analysis to estimate uncollectible reinsurance. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral, and default factors used to determine the portion of a reinsurer’s balance deemed uncollectible. The definition of collateral for this purpose requires some judgment and is generally limited to assets held in trust, letters of credit, and liabilities held by the Company with the same legal entity for which the Company believes there is a right of offset. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $2.1 billion at December 31, 2007, collateralizing reinsurance recoverables with respect to certain reinsurers. In addition, the Company has a four year collateralized escrow agreement with WSIC for up to $185 million to protect certain subsidiaries from non-performing third party reinsurers related to the Winterthur Business. For further information see Note 6 to the Consolidated Financial Statements, “Business Combinations.” Default factors require considerable judgment and are determined using the current rating, or rating equivalent, of each reinsurer as well as other key considerations and assumptions.
At December 31, 2007, the use of different assumptions within the model could have a material effect on the bad debt provision reflected in the Company’s Consolidated Financial Statements. To the extent the creditworthiness of the Company’s reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than the Company’s bad debt provision. Such an event could have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
“Commitment” and “In Use” data represent December 31, 2007 accreted values.
On February 15, 2007, the Company amended the letter of credit facility supporting its syndicates at Lloyd’s of London by reducing the aggregate commitments from the participating banks from £500 million to £450 million. On November 14, 2007, the Company renewed the £450 million “Funds at Lloyd’s” facility for a further two years.
On June 22, 2007, three facilities expired - a $2 billion three-year unsecured credit and letter of credit facility issued in 2004, a $500 million 364-day letter of credit facility issued in 2006, and a bilateral 364-day $100 million credit and letter of credit facility issued in 2006.
In March 2004, the Company issued 33 million 6.5% Units in a public offering. Each 6.5% Unit had a stated amount of $25 and consisted of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Class A ordinary shares on May 15, 2007 and (b) a one-fortieth, or 2.5%, ownership interest in a 2.53% senior note with a principal amount of $1,000, issued by the Company due May 15, 2009 (the “2009 Senior Notes”). The 2009 Senior Notes were pledged by the holders to secure their obligations under the purchase contracts. The number of shares issued under the purchase contracts was adjustable based on, among other things, the average share price of the Company for the twenty consecutive trading days ending on the third trading day immediately preceding the stock purchase date and the dividend rate of the Company. On May 2, 2007, the 2009 Senior Notes were remarketed whereby the interest rate was reset in order to generate sufficient remarketing proceeds to satisfy the 6.5% Unit holders’ obligations under the purchase contracts. The Company purchased and retired the aggregate principle amount of the 2009 Senior Notes as a part of that remarketing. On May 15, 2007, the purchase contracts matured and the Company issued Class A ordinary shares in connection therewith. Each purchase contract provided for the sale by the Company of 0.32727 Class A Ordinary shares (the “Shares”) at a price of $25.00. The settlement of the purchase contracts resulted in the Company’s issuance of an aggregate of 10,799,913 Shares for net proceeds of approximately $823 million, a portion of which was used to retire the 2009 Senior Notes.
At December 31, 2005, $45 million was drawn under the syndicated revolving credit facility at an average interest rate in 2005 of 4.5%, and this amount was repaid in January 2006.
The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 11.5 million. The Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the 7.0% Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of the Company’s ordinary shares is above the threshold appreciation price of $80.6 per share. Because the average market price of the Company’s ordinary shares during the period the 7.0% Units were outstanding was below this price, the shares issuable under the purchase contracts were excluded from the computation of net income per ordinary share assuming dilution for the year ended December 31, 2007.
In June 2005, the Company replaced its $1.0 billion 364-day credit and letter of credit facility with a $2.35 billion facility with a tenor of five years. Of the aggregate amount of $2.35 billion, $1.0 billion is available as revolving credit and up to $2.25 billion is available in the form of letters of credit, with the combined total not to exceed $2.35 billion. As at December 31, 2005, approximately $2.1 billion of the 5-year facility was in use in the form of letters of credit.
In September 2001, the Company issued $508.8 million principal amount at maturity (subsequently increased to $514.6 million under the provisions of an upward interest adjustment provision) of LYONs. The accretion rate on the LYONs was originally 2.875% per annum on a semi-annual basis or 2.896% per annum on an annual basis. The accretion rate for the year to September 7, 2004, was increased by 0.645% per annum on a semi-annual basis to 3.52% on a semi-annual basis and 3.551% per annum on an annual basis as a result of the Company’s ordinary share price in the 30-day period leading up to the second put date in September 2003. On September 7, 2004, the Company redeemed the entire issue of LYONs at their accreted value of approximately $317 million, using proceeds from the issuance of the first tranche of Senior Notes due 2014, as described above.
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. The commercial facilities are scheduled for renewal during 2009 through 2012. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedants with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedants. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value 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 business written by the Company and the loss experience of such business.
Given that all of the Company’s Debt Documents contain cross default provisions, this may result in all holders declaring such debt due and payable and an acceleration of all debt due under those documents. If this were to occur, the Company may not have funds sufficient at that time to repay any or all of such indebtedness.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries in Bermuda fall below “A-” (as measured by the financial strength rating from A.M. Best at any time), the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
In addition, the Company maintains off-balance sheet financing arrangements in the form of contingent capital and alternative collateral facilities. For details of these facilities see Note 16, “Off-Balance Sheet Arrangements.”
Credit derivatives have been entered into by both SCA and through the Company’s investment portfolio and have been recorded at fair value. Following the secondary sale of SCA common shares, the Company retained some of these exposures through reinsurance agreements that have certain of these derivatives embedded within them. Valuation of investment related credit derivatives is provided by independent pricing services. Subsequent to June 6, 2007, the Company has received derivative fair values from SCA management and has reviewed the methodology applied in developing those estimates. SCA estimates fair value for investment grade exposures by
monitoring changes in credit quality and selecting appropriate market indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value when appropriate active market indices are available. For credit derivatives where no appropriate market indices are readily available, the Company uses an alternative fair value methodology. Under this methodology, the fair value is determined using a model which is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. In addition, judgment is applied to factors necessary to determine the rates of return and levels of subordination required by a market participant to assume the risks. Where relevant, recent transactions or contract discussions related to similar risks are considered. In general, SCA holds credit derivatives to maturity. Accordingly, changes in the fair value of such credit derivatives are unrealized. Subsequent to June 6, 2007, the change in value of the embedded derivative portion of the financial guarantee reinsurance agreements the Company has with SCA are included in “Net (loss) income from operating affilliates.” For further information on the results recorded relating to the period from June 6, 2007, to December 31, 2007, see Note 3, “Security Capital Assurance (“SCA”)”.
The following tables summarize insurance activities related to credit default swap derivative instruments excluding gains and losses on credit default swaps within the investment portfolio.
Weather and energy derivatives are recorded at fair value, which is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair values are estimated using available market data and internal pricing models using consistent statistical methodologies. Estimating fair value of instruments that do not have quoted market prices requires management’s judgment in determining amounts that could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equity securities investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of twelve months or less. In addition, certain of the Company’s investment managers may, subject to investment guidelines, enter into forward contracts where potential gains may exist. The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. The Company’s net notional foreign currency denominated exposure on foreign exchange contracts was $341.7 million and a payable of $211.5 million as at December 31, 2007 and 2006, respectively, with a net unrealized gain of $0.9 million and $15.5 million as at December 31, 2007 and 2006, respectively.
The Company utilizes a risk management strategy that incorporates the use of derivative financial instruments primarily to reduce its exposure to interest rate risks associated with certain of its assets and liabilities. The Company uses interest rate swaps to convert certain liabilities from a fixed rate to a variable rate of interest and to convert a variable rate of interest from one basis to another. The Company is exposed to credit risk in the event of non-performance by the counterparties to the swap contracts.
The Company designates certain of its derivative instruments as fair value hedges or cash flow hedges and formally and contemporaneously documents all relationships between the hedging instruments and hedged items and links the hedge to specific assets and liabilities. The Company assesses the effectiveness of the hedge, both at inception and on an on-going basis and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.
A portion of the Company’s fixed debt is hedged against changes in the applicable designated benchmark interest rate. In addition, interest rate swaps are used to hedge the changes in fair value of certain fixed rate liabilities and fixed maturity securities due to changes in the designated benchmark interest rate. At December 31, 2007, 2006, and 2005, contracts designated as fair value hedges were in a net unrealized gain position of $143.3 million, $28.1 million, and $23.5 million, respectively. As a result of the fair value hedges, deposit liabilities were increased by $86.0 million at December 31, 2007, decreased by $13.6 million at December 31, 2006 and increased by $27.6 million at December 31, 2005. These interest rate swap hedges resulted in a net increase in net investment income (net of interest expense) of $14.5 million for the year ended December 31, 2007, a net increase of $5.0 million for the year ended December 31, 2006 and a net decrease of $2.2 million for the year ended December 31, 2005. The ineffective portion of the hedges amounted to $17.3 million as part of net realized gains at December 31, 2007, $5.5 million as part of net realized gains at December 31, 2006 and $5.0 million as part of net realized losses at December 31, 2005.
Interest rate swaps are used to hedge a portion of the Company’s floating rate guaranteed investment contracts. These derivatives convert the floating rate guaranteed investment contract payments to a different floating rate basis to better match the cash receipts earned from the supporting investment portfolio. At December 31, 2007, 2006, and 2005, contracts designated as cash flow hedges were in a net unrealized gain position of $3.0 million, $11.4 million, and nil, respectively. These interest rate swap hedges resulted in an increase in interest expense of $6.0 million, a reduction of $6.1 million, and nil for the years ended December 31, 2007, 2006, and 2005, respectively. The ineffective portion of the hedges amounted to $8.4 million as part of net realized losses at December 31, 2007, $3.5 million as part of net realized losses at December 31, 2006 and nil at December 31, 2005.
In March 2007 the Company entered into an interest rate swap agreement in anticipation of the issuance of the 2027 Senior Notes. This transaction, which met the requirements of a cash flow hedge of a forecasted transaction under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, was entered into to mitigate the interest rate risk associated with the subsequent issuance of the 2027 Senior Notes. The gain on the settlement of the swap transaction on May 2, 2007 of $3.8 million was credited to Accumulated Other Comprehensive Income and will be amortized to interest expense over the 20-year term of the related debt.
The Company also uses single name and index credit default swaps, bond and stock index futures to add value to the portfolio where market inefficiencies are believed to exist and to equitize cash holdings of equity managers. These instruments are marked to market and changes in fair values are recorded through net realized and unrealized gains and losses on derivative instruments. The Company measures potential losses in fair values using various statistical techniques. The change in fair value recorded for the bond and stock index futures was a loss of $7.1 million and a gain of $18.9 million for the years ended December 31, 2007 and 2006, respectively.
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed benefit GMIB over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. At December 31, 2007 and 2006, the fair value was represented by liabilities of $12.4 million and $14.3 million, respectively. The change in fair value recorded for the GMIB was a gain of $1.9 million and $2.4 million for the years ended December 31, 2007 and 2006, respectively. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value with changes in fair value recognized in earnings through net realized and unrealized gains and losses on derivative instrument. The change in fair value recorded for these agreements was not material for either of the years ended December 31, 2007 or 2006.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company. In connection with this transaction, the fair value of the put premiums and other related costs, in total of $109.9 million was charged to “Additional Paid in Capital” and a deferred liability (included with “Other liabilities”) of $60.8 million is recorded in the Consolidated Balance Sheet at December 31, 2007.
The areas where significant concentrations of credit risk may exist include unpaid losses and loss expenses recoverable and reinsurance balances receivable (collectively, “reinsurance assets”), investments balances and certain guarantee relationships with SCA.
In addition, the Company underwrites a significant amount of its insurance and reinsurance property and casualty business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During the three years ended December 31, 2007, 2006 and 2005, approximately 18%, 18% and 21%, respectively, of the Company’s consolidated gross written premiums from property and casualty operations were generated from or placed by Marsh & McLennan Companies. During 2007, 2006 and 2005, approximately 17%, 16% and 17%, respectively, of the Company’s consolidated gross written premiums from property and casualty operations were generated from or placed by AON Corporation and its subsidiaries. Both of these companies are large, well established companies and there are no indications that either of them is financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from property and casualty operations in any of the three years ended December 31, 2007, 2006, or 2005.
The Company rents space for certain of its offices under leases that expire up to 2025. Total rent expense under operating leases for the years ended December 31, 2007, 2006 and 2005 was approximately $34.5 million, $35.8 million and $34.9 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
As at December 31, 2007, minority interest in equity of consolidated subsidiaries included third party interests in XL International (Bermuda) Ltd. As at December 31, 2006, minority interest in equity of consolidated subsidiaries included third party interests in the common shares in SCA and XL International (Bermuda) Ltd., and preferred stock issued by XLFA. The balances are summarized as follows:
Includes share repurchases associated with authorized share repurchase programs as well as purchases related to satisfying tax withholding obligations of employees in connection with the vesting of restricted shares granted under the Company's restricted stock plan.
In connection with the maturity of the purchase contracts associated with the 6.5% Units in May 2007, the Company issued 10,799,913 Class A ordinary shares for net proceeds of approximately $823.0 million, a portion of which was used to retire the 2009 Senior Notes.
The Company’s 1999 Performance Incentive Program for Employees (the “1999 Program”) provides for grants of non-statutory stock options, restricted stock, performance shares and performance units to employees of the Company and its subsidiaries who are not subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934. The 1999 Program is administered by the Board of Directors of the Company or the Compensation Committee, as determined from time to time by the Board of Directors. See Note 20(d), “Share Capital - Options”, for additional disclosures of stock option awards.
Restricted stock awards issued under the 1991 and 1999 Performance Incentive Programs vest as set forth in the applicable award agreements. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. The award recipients generally have the rights and privileges of a shareholder as to the restricted stock, including the right to receive dividends and the right to vote such restricted stock. The recipients are not entitled to receive delivery of a stock certificate prior to vesting, nor may any restricted stock be sold, transferred, pledged, or otherwise disposed of prior to the satisfaction of all vesting requirements. As the shares are issued, deferred compensation equivalent to the fair market value on the date of the grant is charged to shareholders’ equity and subsequently amortized over the vesting period. See Note 20(e), “Share Capital - Restricted Stock”, for additional disclosures of restricted stock awards.
In connection with the SCA IPO during 2006, XL Capital and SCA offered eligible employees of SCA the opportunity to exchange all of their outstanding unvested restricted Class A Ordinary Shares of XL Capital and options to purchase Class A Ordinary Shares of XL Capital, which were awarded to such employees under the Company’s plans prior to the IPO, for a long term incentive plan award (the “SCA LTIP Award”) from SCA to be granted under SCA’s Plan (the “Exchange Offer”). Elections under the Exchange Offer became effective on December 12, 2006. Based on the final count of the depositary for the offer, 443,532 eligible options and 97,144 shares of eligible restricted stock of the Company were exchanged under the Exchange Offer and SCA issued SCA LTIP Awards with an aggregate target amount of $4.6 million and $6.8 million, respectively. In the prior year’s financial statements, these options and restricted stock exchanged under the Exchange Offer were included in the cancelled and forfeited line items in the continuity schedules disclosed for stock options and unvested restricted stock, respectively. Approximately $0.5 million of eligible outstanding unvested restricted Class A Ordinary Shares of XL Capital remained outstanding as at December 31, 2007. No options remained outstanding as at December 31, 2007.
The following is a summary of stock options as of December 31, 2007, and related activity for the year then ended for the Company:
Rights to purchase Class A ordinary shares (the “Rights”) were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitles holders of Class A ordinary shares to buy additional ordinary shares with a value of $700 at the then current market price, at an exercise price of $350. The Rights would be exercisable, and would detach from the Class A ordinary shares, only if a person or group were to acquire 20% or more of the Company’s outstanding Class A ordinary shares, or were to announce a tender or exchange offer that, if consummated, would result in a person or group beneficially owning 20% or more of Class A ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of Class A ordinary shares, each Right would entitle the holder (other than such an acquiring person or group) to purchase Class A ordinary shares (or, in certain circumstances, Class A ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company will be entitled to redeem the Rights at $0.01 per Right at any time until the close of business on the tenth day after the Rights become exercisable. The Rights will expire at the close of business on September 30, 2008, and do not have a fair value. The Company has reserved 119,073,878 Class A ordinary shares being authorized and unissued for issue upon exercise of Rights.
The Company maintains defined contribution plans that cover certain employees, as follows:
A contributory defined benefit pension plan exists in the U.K., but has been closed to new entrants since 1996. Membership comprises six active participants, eighteen pensioner participants (receiving payments), and seventy-three terminated and vested participants. Benefits are based on length of service and compensation as defined in the Trust Deed and Rules, and the Plan is subject to triennial funding valuations, the next of which will be conducted in 2010. Current contribution rates are 14.9% and 3% of pensionable salary for employer and employee respectively.
The components of the net benefit cost for the years ended December 31, 2007 and 2006 are as follows:
In 2007, the Company paid dividends of $69.5 million, respectively, to Series A, Series B and Series E preference shareholders.
In 2006, four quarterly dividends were paid at $0.38 per share to all ordinary shareholders of record as of March 15, June 12, September 11 and December 11.
In 2006 and 2005, the Company paid dividends of $40.3 million, respectively, to Series A and Series B preference shareholders.
The Company is not subject to any taxes in the Cayman Islands on either income or capital gains under current Cayman law. The Company has received an undertaking that the Company will be exempted from Cayman Islands income or capital gains taxes until June 2018 in the event of any such taxes being imposed.
The Company has no open examinations by tax authorities in the major jurisdictions in which the Company operates except in the U.K. where the U.K. taxation authority, HM Revenue and Customs, currently has ongoing examinations of the Company’s U.K. income tax returns for the years ended December 31, 2001 to December 31, 2005. The Company believes it is more likely than not that these examinations will be concluded within the next 12 months; however, it is not currently possible to estimate the outcome.
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2007 and 2006 were as follows:
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.K. group net operating losses would be utilized within a reasonable period. Management has reviewed historical taxable income and future taxable income projections for its U.K. 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.K. group, management has determined that the projected U.K. group taxable income (using U.K. rules for group loss relief) will be sufficient to utilize the net operating losses of approximately $624.4 million. Management will continue to evaluate income generated in future periods by the U.K. group in determining the reasonableness of its position. If management determines that future income generated by the U.K. 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.K. portion of the net deferred tax asset, in the amount of $183.8 million.
Shareholders’ equity at December 31, 2007 and 2006 reflected tax benefits of $2.4 million and $1.0 million, respectively, related to compensation expense deductions for stock options exercised by the Company’s U.S. subsidiaries.
For detailed information regarding the Company’s transactions with SCA see Note 3 “Security Capital Assurance”
At December 31, 2007, 2006 and 2005, the Company owned minority stakes in eleven, nine and eight independent investment management companies (“Investment Manager Affiliates”), respectively. These ownership stakes are part of the Company’s asset management strategy, pursuant to which the Company seeks to develop relationships with specialty investment management organizations, generally acquiring an equity interest in the business. The Company also invests in certain of the funds and limited partnerships and other legal entities managed by these affiliates and through these funds and partnerships pay management and performance fees to the Company’s Investment Manager Affiliates.
In the normal course of business, the Company enters into certain quota share reinsurance contracts with a subsidiary of one of its other strategic affiliates, ARX Holding Corporation. During the year ended December 31, 2007, these contracts resulted in reported net premiums of $100.7 million, net paid claims of $29.7 million and reported acquisition costs of $52.9 million. During the same period in 2006, these contracts resulted in reported net premiums of $102.0 million, net paid claims of $12.8 million and reported acquisition costs of $51.0 million. Management believes that these transactions are conducted at market rates consistent with negotiated arms-length contracts.
In addition, the Company entered into a reinsurance contract with another strategic affiliate, ITAÚ XL Seguros Corporativos S.A., which resulted in reported net premiums of approximately $0.35 million, loss reserves of nil, and reported acquisition costs of $0.1 million during the year ended December 31, 2007.
The following is a summary of the unaudited quarterly financial data for 2007 and 2006:
Certain lines of business and transactions previously reported under the Financial Lines segment which formed part of the Company’s financial operations, have been reclassified and reported under property and casualty operations based on the nature of the underlying business.
To facilitate period to period comparisons, certain short-term Accident and Health business previously included in property and casualty operations have been reclassified to life operations to conform to current segment management responsibilities.
During the fourth quarter of 2007 the Company recorded significant losses related to the overall credit market conditions. These losses included the impairment in the value of the Company’s investments in SCA and Primus, losses with respect to the facultative and excess of loss reinsurance agreements with SCA, and significant net realized losses on investments primarily related to estimated charges for ‘other than temporary impairments’ related primarily to deterioration in structured credit assets. For details regarding these losses see Note 3 “Security Capital Assurance” and Note 7 “Investments”.