We maintain office facilities around the world including our headquarters in Bermuda, as well as North America, Europe, Latin America, the Middle East, and Asia Pacific. Most of our office facilities are leased, although we own major facilities in Bermuda, London and Dublin. Management considers its office facilities suitable and adequate for the current level of operations. See Item 8, Note 18(d), "Commitments and Contingencies - Properties," to the Consolidated Financial Statements included herein, for a discussion of our lease commitments for real property.
The underwriting expense ratio related to the property and casualty operations is the sum of acquisition expenses and operating expenses for the Insurance and Reinsurance segments divided by net premiums earned for the Insurance and Reinsurance segments. See Item 8, Note 3, "Segment Information," to the Consolidated Financial Statements included herein, for further information.
This "Management's Discussion and Analysis of Financial Condition and Results of Operations" contains forward-looking statements which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. These statements are based upon current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See "Cautionary Note Regarding Forward-Looking Statements," for a list of additional factors that could cause actual results to differ materially from those contained in any forward-looking statement.
The Private Securities Litigation Reform Act of 1995 ("PSLRA") provides a "safe harbor" for forward-looking statements. Any prospectus, prospectus supplement, Annual Report to common shareholders, proxy statement, Form 10-K, Form 10-Q or Form 8-K or any other written or oral statements made by us or on our behalf may include forward-looking statements that reflect our current views with respect to future events and financial or operational performance. Such statements include forward-looking statements both with respect to us in general, and to the insurance and reinsurance sectors in particular (both as to underwriting and investment matters). Statements that include the words "expect," "estimate," "intend," "plan," "believe," "project," "anticipate," "may," "could," or "would" and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
Actual results may differ materially from those included in such forward-looking statements and therefore you should not place undue reliance on them. A non-exclusive list of the important factors that could cause actual results to differ materially from those in such forward-looking statements includes the following:
changes in the size of our claims relating to unpredictable natural or man-made catastrophe losses due to the preliminary nature of some reports and estimates of loss and damage to date and the likelihood of longer development periods associated with the characteristics of certain catastrophes;
changes in the number of insureds and ceding companies impacted or the ultimate number and value of individual claims relating to natural catastrophe events due to the preliminary nature of reports and estimates of loss and damage to date;
changes in the amount or type of business that we write, whether due to our actions, changes in market conditions or other factors, and the amount of premium attributable to such business;
the impact of changes in the global financial markets, such as the effects of inflation on our business, including on pricing and reserving, changes in interest rates, credit spreads, foreign currency exchange rates and future volatility in the world's credit, financial and capital markets that adversely affect the performance and valuation of our investments, future financing activities and access to such markets, our ability to pay claims or general financial condition;
changes in credit ratings and rating agency policies or practices, which could trigger cancelation provisions in our assumed reinsurance agreements or impact the availability of our credit facilities;
unanticipated constraints on our liquidity, including the availability of borrowings and letters of credit under credit facilities that inhibit our ability to support our operations, including our ability to underwrite policies and pay claims;
bankruptcies or other financial concerns of companies insofar as they affect P&C coverages or claims that we may have as a counterparty;
the effects of mergers, acquisitions and divestitures, including our ability to modify our internal control over financial reporting, changes to our risk appetite and our ability to realize the value or benefits expected, in each case, as a result of such transactions;
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. We undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise, except as required by the federal securities laws.
Prior to the catastrophic events in the second half of 2017, soft market conditions and a low interest rate environment have impacted the P&C insurance and reinsurance markets, with (re)insurance companies looking for ways to lower their cost of capital and improve the returns on their assets. As a result, they are continually re-evaluating their current approach to capital management and are looking toward alternative and secondary markets for enhanced returns, lower expenses and a lower cost of capital. Specifically, insurers find themselves in a market in which they need to have greater scale and diversification as a means to stay relevant in meeting the evolving demands of insureds and at the same time maintain profitability.
In 2017, our focus within our P&C operations was mainly on profitable growth, continued underwriting improvement, customer service and development of new products and solutions. The effect of these efforts shows in our overall premium
Pricing in our International business lines were up 1.4% for the year with most lines contributing to the increase with the exception of property which was flat year over year. Our North America business lines were down approximately 1% for the year mostly driven by our professional lines, partially offset by modest rate increases in environmental, excess & surplus lines and property books. Our Global Lines businesses were down approximately 2% for the year driven by continued competitive conditions across most of the portfolio, partially offset by increases in fine art & specie, accident & health and London wholesale. For the three months ended December 31, 2017, pricing in our International business lines were up 2.8%, our Global Lines businesses were up 1.2% and our North America business lines were largely flat.
During 2017 the underwriting environment continued to be challenging in most of our classes, but we did see evidence of rate improvements with rates up by approximately 1% in the fourth quarter. Price decreases decelerated in 2017 compared to 2016 and with early January 2018 rate observations we are seeing evidence of broad and more sustainable rate improvements.
For the year ended December 31, 2017, rates across the segment were down approximately 1%. Our global catastrophe portfolio was down 2.8% for the year, significantly less than the 5.1% decrease we experienced in 2016. In the remainder of the property treaty book, rates were down 1.5% in 2017.
During 2017 world economies continued to register economic expansion, with many improving through the year. Unlike prior years, the expansion was broad based, with the U.S., Europe and emerging markets growing in tandem. Europe, in particular, had a strong acceleration as the market-friendly outcome of the French elections, together with continued stimulus from the European Central Bank ("ECB"), led to improved sentiment and consumer spending. China was also a positive contributor to growth worldwide, as policy stimulus and rising property prices also made their way to support increased consumption.
weight to expectations of a recovery in inflation. Wage growth has remained muted despite tightness of labor markets around the world.
Financial markets welcomed the positive economic news and lack of inflationary pressures with strong support of risk assets. Developed world equity markets returned over 20%, and emerging markets posted even stronger returns. Sizable spread compression also occurred, with investors benefiting from tighter levels across the credit spectrum. Interest rates traded mostly sideways, except for short U.S. rates, which went up following the Fed rate increases, and long Bunds, which increased moderately given positive economic news in Europe.
Looking ahead, we expect a continuation of the supportive growth environment, as the world economy moves further into the late stage of the business cycle, with capital spending and consumer growth taking center stage as growth contributors. In the U.S., we are likely to see a temporary acceleration as the tax cuts slowly translate into economic growth and contribute to improved consumer sentiment. In China, however, growth is expected to moderate as the authorities reduce expansionary policies and increase structural reforms.
Inflation is expected to increase in 2018, as tighter labor markets put wages under pressure, particularly in the U.S. Even in economies where inflation has been more subdued, conditions are in place for inflation to tick up closer to (but still below) the ECB’s target.
The main risk to this outlook is a faster than anticipated rise in inflation, forcing more drastic tightening by central banks, with the potential negative impact to growth. Also, in China the difficulties in managing the slowdown could cause a growth scare similar to the one witnessed in late 2015.
The following table presents an analysis of our net income (loss) attributable to common shareholders and other financial measures management considers important in evaluating our operating performance for the years ended December 31, 2017, 2016 and 2015:
One way that we evaluate the performance of our P&C operations is by underwriting profit or loss. Underwriting profit or loss is also a key component of our net income. We do not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from net premiums earned less net losses incurred and expenses related to underwriting activities.
2017 vs. 2016: The 14.1 percentage point increase in our combined ratio was the result of a 15.3 percentage point loss ratio increase, mostly attributable to significant natural catastrophe activity during the year. The loss ratio increase is partially offset by a decrease in the underwriting expense ratio of 1.2 percentage points, which was mainly driven by decreases in our operating expense ratio, which are due to a reduction in variable compensation costs resulting from the natural catastrophe loss impact on our results, synergies realized through integration efforts, as well as the completion of integration during the year. See "Significant Items Affecting the Results of Operations - The impact of natural catastrophe loss events" for additional information on natural catastrophe loss activity.
The following table presents the net income and earnings per common share for the years ended December 31, 2017, 2016 and 2015:
2016 vs. 2015: The decrease in our net income, basic EPS and diluted EPS for the year ended December 31, 2016 were attributable to movements within our Life retrocession derivative, as discussed in Item 8, Note 7, "Derivative Instruments," to the Consolidated Financial statements included herein, as well as increased losses and loss expenses incurred, due to natural catastrophe activity during the year, as noted above. Additionally, in 2015, we recognized the gain on the sale of our operating affiliate, ARX Holding Corp. ("ARX"), as discussed in Item 8, Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," to the Consolidated Financial Statements included herein.
Operating net income per common share is calculated by dividing non-GAAP operating net income by the weighted average number of common shares and common share equivalents outstanding for each period combined with the impact from dilution of share-based compensation and certain conversion features where dilutive.
2016 vs. 2015: The decrease in operating income is due mainly to the increased natural catastrophe activity as noted above.
Operating return on average common shareholders' equity ("Operating ROE") is another non-GAAP financial measure that we consider important in evaluating our operating performance for the same reasons noted in Operating net income above. Operating ROE is a widely used measure of any company's profitability that is calculated by dividing non-GAAP operating net income for any period by the average of the opening and closing common shareholders' equity. In addition, compensation of our senior officers is dependent on, among other factors, the achievement of our performance goals to enhance common shareholder value as measured by Operating ROE (as may be adjusted for certain items as determined by our Management Development and Compensation Committee).
Operating return on average common shareholders' equity excluding accumulated other comprehensive income ("AOCI") ("Operating ROE ex-AOCI") is an additional non-GAAP financial measure of our profitability. The most significant component of this financial measure is the exclusion of mark to market fluctuations on our investment portfolio that have not been realized through sales. We believe that this is a meaningful measure because it demonstrates our core performance as a (re)insurance company without the impact of investment market volatility. Operating ROE ex-AOCI is derived by dividing non-GAAP operating net income for any period by the average of the opening and closing common shareholders' equity excluding AOCI.
Operating return on average common shareholders' equity excluding integration costs ("Operating ROE ex-integration") is an additional non-GAAP financial measure of our profitability that eliminates the impacts of integration costs related to the Catlin Acquisition. Integration costs related to the Catlin Acquisition were completed in the second quarter of 2017. Operating ROE ex-integration is derived by dividing non-GAAP operating net income excluding integration costs for any period by the average of the opening and closing common shareholders' equity.
The following table presents the measures discussed above for the years ended December 31, 2017, 2016 and 2015:
2017 vs. 2016: The decreases in our Operating ROE metrics were principally attributable to the significant natural catastrophe activity as noted above.
The following is a reconciliation of net income (loss) attributable to common shareholders to operating net income (loss) and also includes the calculation of our Operating ROE measures for the years ended December 31, 2017, 2016 and 2015 and Fully diluted TBVPS at December 31, 2017, 2016 and 2015, as well as information about goodwill and intangible assets, outstanding shares and shareholders' equity, which are used in various of the non-GAAP financial measures:
Diluted weighted average number of common shares outstanding is used to calculate per share data except when it is anti-dilutive to earnings per share or when there is a net loss. When it is anti-dilutive or when a net loss occurs, basic weighted average common shares outstanding is utilized in the calculation of net loss per share and net operating loss per share.
Our net income and other financial measures as shown above for the year ended December 31, 2017 were affected by, among other things, the following significant items:
6) The revaluation of our net deferred tax asset as a result of the U.S. Tax Cuts and Jobs Act
The Company initially recognized approximately $75 million as the pre-tax impact of the rate change on the Company's carried reserves for relevant lines of business, primarily related to our U.K. motor business in the Reinsurance segment. Classes of business impacted by this rate change are U.K. motor bodily injury, U.K. employer's liability, and U.K. public liability. Impacts on the Insurance segment were modest due to the low level of U.K. bodily injury claims in our portfolio as well as reinsurance protections.
Since this initial recognition, we have continued to analyze emerging claims data on the impacted motor portfolios and released $12.5 million of incurred but not reported loss reserves, lowering our ultimate pre-tax impact to $62.5 million.
We have not been a large writer of U.K. motor business, but have some exposure from business written on a non-proportional reinsurance basis. This portfolio was scaled back beginning in 2009 as periodic payment orders became more prevalent and more costly.
Notable natural catastrophes for the years ended December 31, 2017, 2016 and 2015 and the underwriting loss incurred (in parenthetical) for the most significant natural catastrophes, in terms of our losses net of reinsurance recoveries and reinstatement premiums, were as follows:
During the year ended December 31, 2017, the positive mark to market change of $296.9 million on our AFS investments, including Other Investments, was primarily driven by an increase in interest rates and by tightening credit spreads across our major jurisdictions. An increase in equity index prices also contributed to the positive mark to market change from our equity portfolio. This represents an approximately 0.8% appreciation in average total investment assets for the year ended December 31, 2017.
Net realized gains on investments in the year ended December 31, 2017 totaled $122.2 million, including net realized losses of approximately $13.3 million related to other-than-temporary impairment ("OTTI") charges on certain of our fixed income investments. For further analysis of this, see "Income Statement Analysis" below.
The U.S. Tax Cuts and Jobs Act was passed in December 2017, reducing the U.S. corporate income tax rate. As a result, we realized a one-time charge of $100.5 million in 2017 due to the revaluation of our net deferred tax asset. See Item 8, Note 23, "Taxation" to the Consolidated Financial Statements included herein for further discussion.
For a discussion of the repurchase of preference shares and subordinated notes issued by our subsidiaries, XLIT and Catlin Insurance Company Ltd. ("Catlin-Bermuda"), please see Item 8, Note 19, "Share Capital and Item 8, Note 14, "Notes Payable and Debt and Financing Arrangements," to the Consolidated Financial Statements included herein, respectively.
Our risk management and risk appetite framework is outlined in Item 1, "Business - Enterprise Risk Management," included herein. The table below shows our estimated per event net 1% and 0.4% exceedance probability exposures for certain peak natural catastrophe peril regions based on our evaluation and detailed analysis with a measurement date of October 1, 2017. These estimates assume that amounts due from reinsurance and retrocession purchases are 100% collectible. There may be credit or other disputes associated with these potential receivables.
Detailed analyses of aggregated in-force exposures and probable maximum loss levels are done periodically. The measurement dates represent the date of the last completed detailed analysis by geographical zone.
We continue to monitor and assess regulatory initiatives and legislation relevant to our business. In particular, we continue to monitor closely and assess relevant developments and proposals regarding national, regional and global capital standards that affect us or in the future could affect us.
On September 12, 2017, we announced that the BMA our group supervisor, had approved the use of a full internal model to calculate our enhanced capital requirements in substitution of the Bermuda Solvency Capital Requirement standard formula.
See "Business - Regulation," included in Item 1 for additional discussion of regulatory matters, including group supervision and Solvency II. In addition, see "Brexit-Related Recent Developments" below for a discussion of Brexit.
In the U.K., we will retain Catlin Insurance Company Ltd ("CICL UK"), a U.K. regulated insurance company, and our Lloyd’s of London ("Lloyd's") operations. The ability to issue both Lloyd's and CICL UK paper in the U.K. as well as XLICSE paper in the E.U. well positions us for business that could otherwise be disrupted from any loss of passporting rights as a result of the U.K. leaving the E.U. With these changes, we anticipate being able to provide continuity of service to our clients and brokers although there can be no assurances that business will not be interrupted. We continue to review our European legal entity structure to consider other possible changes that may need to be made to preserve our E.U.-domiciled entities' passporting regime.
In addition to the potential impact on our ability to passport within the E.U., management is also focused on the impact of Brexit on the free movement of our approximately 2,000 employees within the E.U. A curtailment post-Brexit of free movement of workers between the U.K. and the E.U. could impact the availability and cost of attracting and retaining talent. Further, as no member country has left the E.U. to date, and the rules for exit under article 50 are brief, this has created, and may continue to create, the potential for geopolitical, structural, legal, regulatory, monetary and economic uncertainty, which we expect may continue to have meaningful repercussions in future periods. For more information regarding Brexit, see Item 1A. "Risk Factors" included herein.
Climate change is having an unpredictable effect on the environment within which we work and live, manifesting in both an increase in the global mean temperature and rising sea levels. The local impacts of these changes are difficult to predict, which in turn increases risk. Through our risk managers and risk transfer partners, we are focused on understanding the data behind climate and extreme weather events, and have funded our own research, focused on topics such as thermohaline circulation, ocean acidification, sea ice thickness and measuring the health of global reefscapes.
We provide insurance solutions to renewable energy system manufacturers, developers, owners, lenders and investors looking to have a positive impact on climate change. Our projects have spanned a range of renewable energy and clean energy technologies, including solar, wind, waste-to-energy, fuel cell, energy storage, and energy efficiency. We are not limited to specific technologies, and we have addressed a variety of projects. Our core focus has been the risk associated with new, relatively unproven technologies and the long term performance of projects using those technologies. We are not constrained by geography or the magnitude of the risks that our clients seek to insure or finance.
While the proportion of unpaid losses and loss expenses represented by IBNR is sensitive to a number of factors, the most significant ones have historically been accelerated business growth and changes in business mix. Other factors that have affected the ratio in the past include additions to prior period reserves, catastrophic occurrences, settlement of large claims and changes in claims settlement patterns.
The following table shows the recorded estimate and the high and low ends of the range of our net unpaid losses and loss expenses for each of the lines of business noted above at December 31, 2017:
The development of a reserve range models the uncertainty of the claim environment as well as the limited predictive power of past loss data. These uncertainties and limitations are not specific to us. The ranges represent an estimate of the range
of possible outcomes over a one year development period. A range of possible outcomes should not be confused with a range of best estimates. The range of best estimates will generally be much narrower than the range of possible outcomes, as it will reflect reasonable actuarial best estimates of the expected reserve.
The recognition of unpaid losses and loss expenses recoverable requires two key judgments. The first judgment involves our estimation of the amount of gross IBNR to be ceded to reinsurers. Ceded IBNR is generally developed as part of our loss reserving process and, consequently, its estimation is subject to similar risks and uncertainties as the estimation of gross IBNR (see Item 8, Note 10, "Losses and Loss Expenses," to the Consolidated Financial Statements included herein). The second judgment involves our estimate of the amount of the reinsurance recoverable balance that we will ultimately be unable to recover from 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. Changes in the bad debt provision are reflected in net income. See Item 8, Note 12, "Reinsurance," to the Consolidated Financial Statements included herein, for further information.
The majority of our retained reserves relates to reinsurance of disability income protection for an in-force block of business. Future policy benefit reserves include the lock-in of assumptions at inception with periodic review against experience. The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide income if the policyholder becomes sick or disabled. The liabilities are therefore driven mainly by the rates at which policyholders become sick (where sickness is defined by the policy conditions) and by the rates at which these policyholders recover or die. A 1% increase in the incidence rate would increase the value of future claims by approximately $0.8 million, while a 1% decrease in the termination rate would increase the value of future claims by approximately $1.3 million.
We review, on a quarterly basis, the entirety of the fixed maturity securities in our investment portfolio that are in a gross unrealized loss position to assess whether we believe a credit loss, relative to the current amortized cost of the security, exists. We utilize specific screening criteria to identify securities at risk for a credit loss, and if any of these conditions exist, subject the individual security to a detailed review to determine if a credit loss exists. The screening criteria used by us include the absolute degree of impairment of the security as a percentage of amortized cost, the credit rating of the security and the market yield-to-maturity of the security. Any securities that have previously been identified as impaired due to credit losses are at elevated risk of further impairments. In addition, on a quarterly basis, we review any current market developments, identify any
Key Assumptions used in determination of credit losses related to equities and other investments
We utilize the asset and liability method of accounting for income taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, we determine deferred tax assets and liabilities on the basis of the differences between the financial statement and tax bases of assets and liabilities by using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
We record uncertain tax positions in accordance with ASC 740 "Income Taxes" on the basis of a two-step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon settlement with the tax authority.
For further information, see "Other Revenues and Expenses" and Item 8, Note 23, "Taxation," to the Consolidated Financial Statements included herein.
On proportional contracts, written premiums are estimated based on expected ultimate premiums using information provided by the ceding companies. The ceding company's premium estimate may be adjusted based on a number of factors including its history of providing accurate premium estimates. When the actual premium is reported by the ceding company, normally on a quarterly basis, it may be materially higher or lower than the estimate. Adjustments arising from the reporting of the actual premium by the ceding companies are recorded at the earliest point in time that the supporting information indicates an adjustment is appropriate.
Reinstatement premiums are recognized at the time a loss event occurs. See Item 8, Note 1(d), "Significant Accounting Policies - Premiums and Acquisition Costs" regarding our accounting policies on the recognition of these premiums.
The amount of proportional and excess of loss reinsurance gross premiums written and acquisition expenses recognized by our Reinsurance segment for each line of business for the years ended December 31, 2017, 2016 and 2015 was as follows:
Goodwill represents the excess purchase price over the total identifiable net assets acquired in a business combination. At the time of acquisition, goodwill is assigned to reporting units, which align to our Insurance and Reinsurance segments. Goodwill is subject to testing for impairment at the reporting unit level at least annually, or more frequently if potential impairment indicators exist. This testing first considers qualitative factors relevant to both the Company and the (re)insurance industry to determine whether it is more likely than not (i.e. a greater than 50% probability) that the fair value of the reporting unit is greater than its carrying value. These factors include, but are not limited to, macroeconomic conditions, industry and market conditions and trends in the Company's financial performance. If the reporting unit fails this qualitative test, then it becomes necessary to perform a quantitative test to calculate an estimated fair value of the subject reporting unit, the result of which is then compared to its carrying value to determine whether goodwill is recoverable. A common methodology utilized to perform the quantitative test is a discounted cash flow analysis.
Performing the qualitative test involves judgment in first interpreting positive and negative evidence that may or may not be indicative of a potential impairment. Should the weight of this evidence suggest it is more likely than not that goodwill is impaired, the performance of the quantitative test to estimate fair value would occur. This would also involve significant judgments, such as establishing expectations at the reporting unit level for future revenues and expenses, as well as the appropriate discount rate.
Based on the testing performed for the year ended December 31, 2017, we determined no goodwill impairment was required.
Based on the testing performed for the year ended December 31, 2017, we determined no impairment of intangible assets was required.
We are organized into two operating segments: Insurance and Reinsurance. The results of the Run-Off Life Operations are reported within Corporate and Other. Our general investment and financing operations are also reflected in Corporate and Other. Prior period information has been re-presented to reflect the current presentation.
We evaluate the performance of both the Insurance and Reinsurance segments based on underwriting profit. Other items of our revenue and expenditures are not evaluated at the segment level for reporting purposes. In addition, we do not allocate investment assets by segment for our P&C operations. Investment assets related to our Run-Off Life Operations, and certain structured products included in the Insurance and Reinsurance segments and Corporate and Other are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments. See Item 8, Note 3, "Segment Information," to the Consolidated Financial Statements included herein, for a reconciliation of segment data to our consolidated financial statements.
As outlined in Item 1, "Business," the Insurance segment provides commercial property, casualty and specialty insurance products on a global basis. We report the results of our insurance segment in three underwriting groups: Global Lines, International and North America.
The following is a summary of the premium movements by underwriting business groups:
International - increase of 13.7%, driven mainly by higher new business in international property and an increase in new business and rate improvement in international casualty and international financial lines.
2016 vs 2015: Gross premiums written increased by 14.9%, primarily due to the Catlin Acquisition as 2015 results only reflect eight months of the combined entities. The acquired business portfolios continued to experience some reductions in renewals where premium rates did not support our target returns. The businesses most severely impacted were energy and U.S. Professional. However, retention of business continued to be strong where premium rates were deemed to be adequate.
Global Lines - increase of 47.7%, attributable to an increase in the London wholesale and accident & health business lines largely due to the Catlin Acquisition, new business in political risk & trade credit and portfolio deals business lines and increased renewals in marine and crisis management.
International - increase of 3.6%, driven by increases in renewals and new business in international construction and international financial lines and new business in property international open market. These increases were partially offset by a decrease in international casualty business.
North America - decrease of 0.9%, attributable to lower retention in professional select and design business lines. These decreases were offset in part by increases in new and renewal business in cybertech, global risk management and construction as well as the acquisition of Allied Specialty.
2016 vs 2015: The increase of 14.6% largely resulted from the increase in gross premiums written due to the Catlin Acquisition and other factors as noted above.
2016 vs 2015: The increase of 17.8% is mainly attributable to the increase in gross premiums written as noted above as well as some favorable movement in ceded premiums earned due to decreases in reinsurance pricing as a result of favorable market conditions and realized efficiencies in our efforts to integrate the ceded reinsurance portfolio.
2017 vs 2016: The 10.6 percentage point deterioration in the loss ratio excluding prior year development is mainly attributable to a significantly higher level of natural catastrophe activity for 2017 as compared to 2016. Losses net of reinsurance, reinstatement and premium adjustments related to natural catastrophe events for 2017 were $735.6 million higher than in the same period in 2016. Excluding prior year development and net natural catastrophe losses net of reinsurance, reinstatements and premium adjustments, in both years, the loss ratio for the year ended December 31, 2017 compared to the same period of 2016 improved by 0.3 percentage points to 61.1%.
2017 vs 2016: The improvement of 1.3 percentage points was due to an improvement in the operating expense ratio of 1.5 percentage points partially offset by an increase in the acquisition expense ratio of 0.2 percentage points, as follows:
Acquisition expense ratio - slight increase of 0.2 percentage point largely due to changes to business mix.
Acquisition expense ratio - increased 1.0 percentage point mainly due to the acquired business from Catlin, which included a larger share of wholesale Specialty business where the gross acquisition costs are higher than the legacy business.
2017 vs 2016: Net results from structured insurance products decreased compared to the corresponding period of 2016 as a result of a decrease in investment yields.
As outlined in Item 1, "Business," the Reinsurance segment provides casualty, property risk, property catastrophe and specialty on a global basis, with business being written on both a proportional and non-proportional treaty basis and also on a facultative basis. Our reinsurance operations are structured into five business groups, mainly based on region: Bermuda, North America, London, EMEA and LAC.
Bermuda - increase of 47.0%, primarily driven by an increased share written on a large multi-line quota share treaty with one of our core clients. Additional increases are due to new business in property treaty and property catastrophe and reinstatement premiums from significant natural catastrophe activity primarily in the second half of 2017.
EMEA - increase of 4.2%, mainly due to significant new business written within the property treaty and casualty treaty lines. These favorable components were partially offset by cancellations of a non-recurring treaty from the second quarter of 2016 within the casualty auto business. In addition, the region was negatively impacted by a premium adjustment in a professional indemnity contract, due to the cedant exiting this line of business.
LAC - increase of 7.1%, primarily driven by new business within property catastrophe, property treaty and credit lines of business. These increases were partially offset by cancellations in property treaty and prior year adjustments in property catastrophe.
North America - increase of 40.6%, largely related to renewals attributable to the Catlin Acquisition with notable inceptions in property treaty and casualty lines of business.
EMEA - increase of 91.7%, primarily driven by the Catlin Acquisition and new business in motor proportional within casualty, crop and whole accounts business. These increases were partially offset by cancellations and prior year adjustments.
2017 vs 2016: The increase of 15.7% was mainly attributable to the earning impact of a material new contract written within Bermuda during the fourth quarter of 2016. In addition to the impact of this contract, there were additional earned premiums resulting from a refinement of the earning patterns within the European engineering book during the first quarter and significant reinstatement premiums reported during the second half of 2017 related to natural catastrophe activity.
2016 vs 2015: The increase of 23.8% is mainly attributable to the increase in gross premiums written as discussed above. This increase is partially offset by the impact of premiums earned in 2015 from the unearned premium reserve assumed from the Catlin Acquisition, on policies written by the acquired entity prior to the combination of the two companies and the impact of aligning earning patterns of the legacy portfolios.
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 and loss expense reserves held at the beginning of the year. The following table summarizes these components of the loss ratio for the Reinsurance segment for the years ended December 31, 2017, 2016 and 2015:
2017 vs 2016: The 19.8 percentage point deterioration in the loss ratio excluding prior year development was primarily a result of significant natural catastrophe losses. Losses net of reinsurance recoveries, reinstatement and premium adjustments related to natural catastrophe events for 2017 were $642.9 million, or 17.1 percentage points higher than in the same period of 2016. Excluding favorable prior year development and natural catastrophe losses net of reinsurance recoveries, reinstatement and premium adjustments, the loss ratio for 2017 compared to the same period of 2016 deteriorated 2.7 percentage points to 55.5%, primarily due to a change in mix of business, largely resulting from a higher proportion of the other lines of business and a lower proportion of the property catastrophe line of business being written .
For further details on large loss activity including losses from natural catastrophes, see "Significant Items Affecting the Results of Operations - 2) The Impact of Significant Natural Catastrophe and Other Large Loss Events" above.
The following table summarizes the net (favorable) adverse prior year development by line of business relating to the reinsurance segment for the years ended December 31, 2017, 2016 and 2015:
Operating expense ratio - improvement of 1.6 percentage points was attributable to synergies realized due to the Catlin Acquisition and increased operating leverage, as well as a reduction to variable compensation costs resulting from the natural catastrophe loss impact on our results.
2016 vs 2015: The improvement of 3.1 percentage points in the underwriting expense ratio was mainly due to an improvement in the operating expense ratio of 2.2 percentage points, plus an improvement of 0.9 percentage points in the acquisition expense ratio.
Acquisition expense ratio - improvement of 0.9 percentage points, which was due to adjustments to prior underwriting years and change in business mix.
2017 vs 2016: Net results from structured reinsurance products increased compared to the corresponding period in 2016 mainly as a result of a significant reduction of interest expense due to a change in actuarially determined estimates and timing of expected future cash flows related to one contract.
2016 vs 2015: Net results from structured reinsurance products decreased slightly compared to the corresponding period in 2015. The decrease in investment income was mainly a result of lower investment yields. The decrease in interest expenses was mainly due to lower interest resulting from the commutation of a structured indemnity contract.
Our general investment and financing operations are reflected in Corporate and Other. In addition, results of our Run-Off Life Operations are reported within Corporate and Other. We ceased writing new life reinsurance contracts in 2009 and, since that time, have been managing the run-off of our life reinsurance operations.
Subsequent to the completion of the life reinsurance transaction described in Item 8, Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," to the Consolidated Financial Statements included herein, our net income (loss) is subject to variability related to the GreyCastle Life Retro Arrangements, however, there is no recurring net impact on our future comprehensive income in any period. The life retrocession embedded derivative value includes the interest income, unrealized gains and losses, and realized gains and losses from sales of the Life Funds Withheld Assets. For further information on the life retrocession embedded derivative and its impact on our net income (loss), see Item 8, Note 7(c)(iii), "Derivative Instruments - Other Non-Investment Derivatives," to the Consolidated Financial Statements included herein.
During the year ended December 31, 2017, our net loss from our run-off life operations that were not subject to the GreyCastle Life Retro Arrangements was $25.7 million. Included within this result are net realized losses of $11.6 million. Additionally, the net investment income of $30.4 million was partially offset by a net underwriting loss of $32.8 million and interest expense of $11.7 million on the funds withheld for the U.S. Term Life Retro Arrangements.
During the year ended December 31, 2016, our net underwriting result from our Run-Off Life Operations - not subject to Life Retro Arrangements was a loss of $23.3 million and our net investment result relating to our Run-Off Life Operations - not subject to Life Retro Arrangements, including net realized gains and losses, was $4.1 million, producing a net loss of $19.2 million.
The performance of investment portfolios is measured on a local currency basis. For the aggregate performance calculation, respective local currency balances are translated to U.S. dollars at quarter end rates to calculate composite portfolio results.
Performance on the hedge fund portfolio reflects the twelve months ended November 30, 2017 and 2016, respectively, for both equity and non-equity accounted hedge funds.
2017 vs 2016: The increase of 4.5% compared to the prior year period was primarily due to higher reinvestment rates during the year from active sector rotation and portfolio management activities, offset by cash outflows from the investment portfolio and negative foreign exchange movements.
fixed income and equity investments. For further discussion, see Item 8, Note 4, "Investments," to the Consolidated Financial Statements included herein.
Net realized gains on investments of $112.7 million in the year ended December 31, 2016 included realized losses of $78.6 million related to OTTI charges on certain of our fixed income and equity investments, as well as net realized gains of $191.2 million, which resulted primarily from sales of U.S. Government fixed maturities and equities.
2016 vs 2015: Net realized and unrealized gains on derivatives were $2.5 million for the year ended December 31, 2016 compared to $53.1 million for the year ended December 31, 2015. The 2016 gains resulted from our investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments. The 2015 gains resulted from the Catlin Acquisition-related foreign exchange contracts and hedging strategies. For further discussion, see Item 8, Note 7, "Derivative Instruments" to the Consolidated Financial Statements included herein.
Interest expense includes costs related to our debt and collateral facilities and does not include deposit liability accretion, which is included in Net investment results - structured products.
2017 vs 2016: The increase of 81.6% was largely due to the solid results from one of our strategic operating affiliates as well as strong results generated from an investment within our value investing strategy team, offset by weaker results from our strategic insurance-related affiliates as compared to 2016.
2016 vs 2015: The decrease of 62.4% was largely due to the sale of our interest in ARX in 2015, which was one of our larger insurance affiliates that wrote direct U.S. homeowners insurance. See Item 8, Note 2(g), "Acquisitions and Disposals - Sale of Operating Affiliate," for further information on the sale.
2017 vs 2016: The foreign exchange losses of $44.6 million in the year ended December 31, 2017 were principally a result of the weakening of the U.S. dollar against the British pound on net monetary liabilities in that currency held in U.S. dollar denominated units. These losses were partially offset by the gains which resulted from the weakening of the U.S. dollar against the Swiss Franc on net monetary assets held in Swiss Franc on U.S. dollar denominated units.
2016 vs 2015: The increase of 5.1% was mainly a result of increased compensation cost, professional fees and lower rate of recovery of regulatory fees.
The loss on extinguishment of debt is a result of the repurchase transaction described in Item 8, Note 14, "Notes Payable and Debt and Financing Arrangements," to the Consolidated Financial Statements included herein.
The gain on sale of subsidiary during the year ended December 31, 2016 was due to two items. The first was the sale of our 100% wholly-owned subsidiary XL Life Insurance and Annuity Company ("XLLIAC") to Mutual of Omaha Insurance Company ("Omaha") for $20.9 million in September 2016. The second was a sale of 7.8% of common shares and 6.4% of preference shares of New Ocean Capital Management for $3.9 million. For a further discussion, see Item 8, Note 2(b), "Acquisitions and Disposals - Sale of XL Life Insurance and Annuity Company ("XLLIAC")," to the Consolidated Financial Statements included herein.
Item 8, Note 7, "Derivative Instruments," to the Consolidated Financial Statements included herein and "Impact of GreyCastle Life Retro Arrangements" above.
2017 vs 2016: The tax expense of $59.1 million recognized in 2017 was primarily driven by the $100.5 million one-time deferred tax asset write-down as a result of the U.S. Tax Cuts and Jobs Act, partially offset by the tax benefit related to the catastrophe losses incurred during 2017. Excluding the U.S. Tax Cuts and Jobs Act charge, the remaining 2017 tax benefit differed significantly from the 2016 tax expense due to the geographical distribution of group profits and losses between taxable and non-taxable jurisdictions.
As described in Item 1, "Business - Investments," Item 8, Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," and Note 4, "Investments," to the Consolidated Financial Statements included herein, the Life Funds Withheld Assets are managed pursuant to agreed-upon investment guidelines that meet the contractual commitments of our ceding companies and applicable laws and regulations. All of the investment results associated with the Life Funds Withheld Assets ultimately accrue to GCLR. Because we no longer share the risks and rewards of the underlying performance of the supporting invested assets, disclosures within the financial statement notes included herein, and in the table below, separately report the Life Funds Withheld Assets from the rest of our investments. The remaining disclosures in this section exclude the Life Funds Withheld Assets.
We review our fixed income investments on a regular basis to consider their concentration, credit quality and compliance with established guidelines. At December 31, 2017 and 2016, the average credit quality of our total fixed income portfolio was "AA." Included in the table below are the credit ratings of the fixed income portfolio, excluding cash and Life Funds Withheld Assets December 31, 2017 and 2016:
gross unrealized losses of $85.3 million related to the Government holdings. Securities in a gross unrealized loss position had a fair value of $5.6 billion at December 31, 2017.
gross unrealized losses of $35.1 million related to RMBS. Securities in a gross unrealized loss position had a fair value of $3.1 billion at December 31, 2017.
The following table details the security type and length of time that AFS securities were in a continual gross unrealized loss position at December 31, 2017:
Our exposure to this European sovereign debt has a fair value of $171.2 million at December 31, 2017, and includes direct investment in fixed maturity securities issued by national and local governments of the European Periphery Nations, as well as fixed maturity securities issued by certain corporate entities operating within the European Periphery Nations. We continue to monitor our financial exposure, and continually assess the impact of a potential default by any of the European Periphery Nations on their respective debt issuances, including the associated impact on non-sovereign entities in these five nations in the event of such a default.
We currently have no unfunded investment exposures or commitments to either sovereign or non-sovereign entities within the European Periphery Nations. We do invest in various hedge funds and private investments that from time to time may invest in securities or investments related to the European Periphery Nations. In general, such funds will invest in debt and/or equity securities of individual corporate issuers, securitized debt instruments and/or fixed maturity instruments issued by national governments of the European Periphery Nations. As market volatility in the European Periphery Nations has declined, we have observed that our hedge fund and private fund managers have increased their exposure to these countries. We estimate that as of December 31, 2017, our aggregate exposure to European Periphery Nations via our fund investments did not exceed $200 million on a net basis. The exposure was diversified across issuers and instruments and across the five European Periphery Nations.
Where broker quotes are the primary source of the valuations, sufficient information regarding the specific inputs utilized by the brokers is generally not available to support a Level 2 classification. We obtain the majority of broker quoted values from third party investment managers who perform independent verifications of these valuations using pricing matrices based upon information gathered by market traders. In addition, for the majority of these securities, we compare the broker quotes to independent valuations obtained from third party pricing vendors, which may also consist of broker quotes, to assess if the prices received represent a reasonable estimate of the fair value.
At December 31, 2017, the fair value of total assets and liabilities carried at fair value, the fair value of Level 3 assets and liabilities and the percentage of Level 3 assets to our total assets and liabilities that are carried at fair value were as follows:
See Item 8, Note 8, "Fair Value Measurements," to the Consolidated Financial Statements included herein, for an analysis of the change in fair value of Level 3 assets and liabilities.
In the normal course of business, we seek to reduce the potential amount of loss arising from claims events by reinsuring certain levels of risk assumed in various areas of exposure with other insurers or reinsurers. While reinsurance agreements are designed to limit our losses from large exposures and permit recovery of a portion of direct unpaid losses, reinsurance does not relieve our ultimate liability to the insureds. Accordingly, the losses and loss expense reserves on the Consolidated Balance Sheets represent our total unpaid gross losses. Unpaid losses and loss expense recoverable relates to estimated reinsurance recoveries on the unpaid loss and loss expense reserves.
We have credit risk should any of our reinsurers be unable or unwilling to settle balances, net of collateral, due. For further discussion, please see Item 8, Note 12, "Reinsurance," to the Consolidated Financial Statements included herein.
As holding companies, XL Group and XLIT have no operations of their own and their assets consist primarily of investments in subsidiaries. XL Group's principal uses of liquidity are common share-related transactions, including dividend payments to holders of its common shares as well as share buybacks, capital investments in its subsidiaries and certain corporate operating expenses. XLIT's principal uses of liquidity are preference share related transactions, including dividend payments to its preference shareholders as well as preference share buybacks from time to time, interest and principal payments on debt, dividends to its parent company and certain corporate operating expenses.
We believe that we have adequate capital resources in the aggregate, and that our subsidiaries have the ability to produce sufficient cash flows, to meet expected claims payments and operational expenses and to provide dividend payments to XLIT and XL Group. In turn, we anticipate that we will have adequate capital resources, or the access to capital resources, to meet our obligations, including but not limited to dividend payments to our shareholders, interest payments on our senior and subordinated notes and other liabilities as they come due.
At December 31, 2017, on a consolidated basis we had cash and cash equivalents of approximately $3.4 billion, as compared to approximately $3.4 billion at December 31, 2016. We have three main sources of cash flows - those provided by operating, investing activities and financing activities:
Historically, cash receipts from operations that are typically derived from the receipt of investment income on our investment portfolio as well as the net receipt of premiums less claims and expenses related to our underwriting activities have generally provided sufficient funds to pay losses as well as operating expenses of our subsidiaries and to fund dividends payable by our subsidiaries to XLIT, and ultimately, XL Group. Our operating subsidiaries provide liquidity in that premiums are generally received months or even years before losses are paid under the policies related to such premiums. Premiums and acquisition expenses are settled based on terms of trade as stipulated by an underwriting contract, and generally are received within the first year of inception of a policy when the premium is written, but can be up to three years on certain reinsurance business assumed. Operating expenses are generally paid within a year of being incurred. Claims, especially for casualty business, may take a much longer time before they are reported and ultimately settled, requiring the establishment of reserves for unpaid losses and loss expenses. Therefore, the amount of claims paid in any one year is not necessarily related to the amount of net losses incurred in that year, as reported in the Consolidated Statements of Income.
As further outlined in Item 8, Note 4, "Investments," to the Consolidated Financial Statements included herein, certain assets of the investment portfolio are pledged as collateral. At December 31, 2017 and 2016, we had $18.8 billion and $17.1 billion in pledged assets, respectively. Of these pledged assets, we have determined in accordance with the accounting policy outlined in Item 8, Note 1(i), "Significant Accounting Policies - Cash and Cash Equivalents," to the Consolidated Financial Statements included in herein, that cash in the amount of $157.5 million and 153.5 million at December 31, 2017 and 2016 is restricted and has been disclosed as such in our Consolidated Balance Sheets.
revolving credit facilities as a back-up for potential short-term liquidity needs.
Consolidation within the banking industry may result in the aggregate amount of credit provided to us being reduced. We attempt to mitigate this risk by identifying and/or selecting additional banks that can participate in the credit facilities upon renewal. See Item 1A, "Risk Factors - We may require additional capital in the future, which may not be available to us on satisfactory terms, on a timely basis or at all," included herein.
The Series D preference ordinary shares and the Series E preference ordinary shares were issued by XLIT. As a result of the Catlin Acquisition, we also assumed the obligation of the preference shares issued by Catlin-Bermuda. These instruments represent non-controlling interests in our consolidated financial statements and are presented as non-controlling interest in equity of consolidated subsidiaries as noted in the table above.
The following table presents the Company's outstanding notes payable and debt as of December 31, 2017:
Our credit facilities contain a number of covenants that must be met and maintained and that, among other things, could restrict, subject to certain exceptions, our financial flexibility including the ability to:
The following outlines our most restrictive financial covenant requirements across all credit facilities and actual amounts as of December 31, 2017:
Secured indebtedness excludes secured letter of credit facilities as permitted under the schedules to the credit facilities. At December 31, 2017, such secured letter of credit facilities amounted to $1.38 billion.
As noted in the table above, at December 31, 2017, we were in compliance with all covenants by significant margins, and we currently remain in compliance.
The following table presents our long term contractual obligations and related payments at December 31, 2017, due by period. This table excludes further commitments of $390.6 million related to our investment funds and certain limited partnerships, and in use letter of credit facilities of $2.5 billion. See Item 8, Note 14, "Notes Payable and Debt and Financing Arrangements," Note 7, "Derivative Instruments," and Note 18, "Commitments and Contingencies," to the Consolidated Financial Statements included herein, for further information.
Future policy benefit reserves related to Run-Off Life Operations were $3.6 billion on our Consolidated Balance Sheet at December 31, 2017. Amounts reflected above include an allowance for future premiums in respect of contracts under which premiums are payable throughout the life of the underlying policy. The value of the discount is also included for those lines of business that have reserves where future claim payments and future premium receipts can be estimated using actuarial principles. The timing and amounts of actual claims payments and premium receipts related to these reserves vary based on the underlying experience of the portfolio. Typical elements of the experience include mortality, morbidity and persistency. The ultimate amount of the claims payments and premium receipts could differ materially from our estimated amounts.
Consolidated Statements of Cash Flows for the years ended December 31, 2017, 2016 and 2015
Notes to Consolidated Financial Statements for the years ended December 31, 2017, 2016 and 2015
20. Computation of Earnings Per Common Share and Common Share Equivalent
XL Group Ltd, a Bermuda exempted company ("XL Group"), through its operating subsidiaries, is a leading provider of insurance and reinsurance coverages to industrial, commercial and professional firms, insurance companies and other enterprises on a worldwide basis.
XL Group and its various subsidiaries operate globally in 29 countries, through the Company's two business segments: Insurance and Reinsurance. These segments are further discussed in Note 3, "Segment Information."
On July 25, 2016, XL Group plc, an Irish public limited company ("XL-Ireland"), and XL Group completed a scheme of arrangement under Irish law (the "Scheme of Arrangement") that effected a transaction (the "Redomestication") that resulted in the shareholders of XL-Ireland becoming shareholders of XL Group and XL-Ireland becoming a subsidiary of XL Group. In accordance with the terms of the Scheme of Arrangement, the following steps simultaneously occurred at the effective time of the Redomestication: (i) all of the existing XL-Ireland ordinary shares, par value $0.01 per share (the "XL-Ireland shares") (other than XL-Ireland shares held by XL Group) were canceled; (ii) the reserves created on cancellation of the XL-Ireland shares were used to issue XL-Ireland shares to XL Group; and (iii) in return for such issuance of XL-Ireland shares to XL Group, XL Group issued common shares, par value $0.01 per share (the "XL Group shares"). The XL Group shares issued in connection with the Redomestication were issued in reliance upon an exemption from registration under the U.S. Securities Act of 1933, as amended (the "Securities Act"), provided under Section 3(a)(10) of the Securities Act. Upon the Redomestication, XL Group became the successor issuer to XL-Ireland and succeeded XL-Ireland's obligation to file reports, proxy statements and other information required of domestic registrants by the Securities Exchange Act of 1934, as amended (the "Exchange Act"), with the U.S. Securities and Exchange Commission (the "SEC"). As the successor issuer, the XL Group shares were deemed to be registered under Section 12(b) of the Exchange Act. Further, XL Group is subject to the applicable listing standards of the New York Stock Exchange ("NYSE"), and reports its financial results in U.S. dollars and accounting principles generally accepted in the United States of America ("GAAP"), in addition to any reporting requirements under Bermuda law. XL Group's shares continue in place of the XL-Ireland shares to trade on the NYSE under the ticker symbol "XL." Additionally, upon completion of the Redomestication, XL Group fully and unconditionally guaranteed the majority of the outstanding debt issued by XLIT Ltd., an exempted company incorporated under the laws of the Cayman Islands ("XLIT"). See Note 14, "Notes Payable and Debt and Financing Arrangements," for more information regarding our outstanding debt.
Prior to July 25, 2016, unless the context otherwise indicates, references herein to the "Company" or "XL" are to, and these financial statements include the accounts of, XL-Ireland and its consolidated subsidiaries. On and subsequent to July 25, 2016, unless the context otherwise indicates, references herein to the "Company" or "XL" are to, and these financial statements include the accounts of, XL Group and its consolidated subsidiaries.
On May 1, 2015, the Company completed its acquisition (the "Catlin Acquisition") of Catlin Group Limited and its consolidated subsidiaries ("Catlin"). Catlin, through its wholly-owned subsidiaries, provided property, casualty and specialty insurance and reinsurance coverage on a worldwide basis. The Company's consolidated results of operations include those of Catlin from May 1, 2015. See Note 2(f), "Acquisitions and Disposals - Catlin Acquisition," for additional information with respect to the acquisition of Catlin.
These consolidated financial statements include the accounts of the Company and all of its subsidiaries. These consolidated financial statements have been prepared in conformity with GAAP. To facilitate period-to-period comparisons, certain reclassifications have been made to prior year consolidated financial statement amounts to conform to the current year presentation. There was no effect on net income from this change in presentation.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company's most significant areas of estimation include:
Level 3 - Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Unobservable inputs reflect the reporting entity's own assumptions about the assumptions that market participants would use in pricing the asset or liability. Level 3 assets and liabilities include financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
Fair values of investments and derivatives are based on published market values if available, estimates of fair values of similar issues, or estimates of fair values provided by independent pricing services and brokers. Fair values of financial instruments for which quoted market prices are not available or for which the Company believes current trading conditions represent distressed markets are based on estimates using present value or other valuation techniques. The fair values estimated using such techniques are significantly affected by the assumptions used, including the discount rates and the estimated amounts and timing of future cash flows. In such instances, the derived fair value estimates cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts that would be realized in a current market exchange.
Investments that are considered available for sale ("AFS") (comprised of fixed maturities, equity securities and short-term investments) are carried at fair value. The fair values for AFS investments are generally sourced from third parties. The fair values of fixed income securities are based upon quoted market values where available, "evaluated bid" prices provided by third party pricing services ("pricing services") where quoted market values are not available, or by reference to broker or underwriter bid indications where pricing services do not provide coverage for a particular security. To the extent the Company believes current trading conditions represent distressed transactions, the Company may elect to utilize internally generated models.
Short-term investments include investments due to mature within one year from the date of purchase and are valued using the same external factors and in the same manner as fixed income securities.
Investment income is recognized when earned, and includes interest and dividend income together with the amortization of premium and discount on fixed maturities and short-term investments, and is recorded net of related investment expenses. Amortization of discounts on fixed maturities includes amortization to expected recovery values for investments that have previously been recorded as other-than-temporarily impaired. For mortgage-backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Prepayment fees or call premiums that are payable to the Company only when a security is called prior to its maturity are earned when received and reflected in net investment income.
Investments for which the Company has elected the fair value option are classified as "trading". Trading securities are carried at fair value. All trading securities are held in support of the GreyCastle Life Retro Arrangements as defined in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation." Thus, changes in the fair value of trading securities are included in "Net unrealized gains (losses) on investments, trading securities - Life Funds Withheld Assets," and interest and dividend income from trading securities are included as a component of "Net investment income - Life Funds Withheld Assets".
Designated investments that support the GreyCastle Life Retro Arrangements, which were written on a funds withheld basis ("Life Funds Withheld Assets") and entered into in connection with the sale of our life reinsurance subsidiary, are classified as either available for sale or trading. Investment results for these assets - including interest income, unrealized gains and losses, and gains and losses from sales - are passed directly to the reinsurer pursuant to a contractual arrangement that is accounted for as a derivative.
Changes in the fair value of the embedded derivative associated with the GreyCastle Life Retro Arrangements are recorded in "Net realized and unrealized gains (losses) on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets" on the Consolidated Statements of Income. The fair value of the embedded derivative is included within "Funds withheld on life retrocession arrangements, net of future policy benefit reserves recoverable" on the Consolidated Balance Sheets.
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 Consolidated Balance Sheets 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 of the investee shareholders' 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 recently available financial statements are used. This lag in reporting is applied consistently. Distributions received from affiliates representing returns on invested capital are recorded as operating cash flows, while distributions representing returns of invested capital or proceeds upon sale of all or a portion of an affiliate are recorded as investing cash flows.
Fair values for other investments, principally other direct equity investments, investment funds and limited partnerships, are primarily based on the net asset value provided by the investment manager, the general partner or the respective entity, recent financial information, available market data and, in certain cases, management judgment. These entities generally carry their trading positions and investments, the majority of which have underlying securities valued using Level 1 or Level 2 inputs, at fair value as determined by their respective investment managers; accordingly, these investments are generally classified as
Insurance premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums written are recorded at the inception of the policy and are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
Premiums are generally earned on a pro-rata basis over the period the coverage is provided. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force. Net premiums earned are presented after deductions for reinsurance ceded, as applicable. Premiums receivable are reported net of commissions payable and allowance for estimated uncollectible amounts.
recognized. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provisions are made for estimated unrecoverable reinsurance.
Fee income and other includes fees received for insurance, loss prevention consulting services and product structuring services provided and is earned over the service period of the contract. Any adjustments to fees earned or the service period are reflected in income in the period when determined.
With respect to securities where the decline in value is determined to be temporary and the security's amortized cost 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. We have outsourced a significant portion of the day-to-day management of the Company's investment portfolio to third party investment manager service providers. While these investment manager service providers 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
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other-than-temporary. These include subsequent significant changes in general economic conditions as well as specific business conditions affecting particular issuers, subjective assessment of issue-specific factors (seniority of claims, collateral value, etc.), future financial market effects, stability of foreign governments and economies, future rating agency actions and significant disclosure of accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, significant assumptions and management judgment are involved in determining if the decline is other-than-temporary. If management determines that a decline in fair value is temporary, then a security's value is not written down at that time. However, there are potential effects upon the Company's future earnings and financial position should management later conclude that some of the current declines in the fair value of the investments are other-than-temporary declines.
The Company recognizes all derivatives as either assets or liabilities on the Consolidated Balance Sheets and measures those instruments at fair value. Except for the embedded derivative associated with the GreyCastle Life Retro Arrangements discussed above within (c) "Investments Related to Life Retrocession Arrangements written on a Funds Withheld Basis," the changes in fair value of derivatives are shown in the Consolidated Statements of Income as "net realized and unrealized gains (losses) on derivative instruments," unless the derivatives are designated as hedging instruments. The accounting for derivatives that are designated as hedging instruments is discussed below. Changes in the fair value of derivatives may create volatility in the Company's results of operations from period to period. Amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) are offset against net fair value amounts recognized in the Consolidated Balance Sheets for derivative instruments executed with the same counterparty under the same netting arrangement to the extent that the Company intends to settle the amounts on a net basis.
To qualify for hedge accounting treatment, a derivative must be highly effective in mitigating the designated changes in value or cash flow of the hedged item. At hedge inception, the Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking each hedge transaction. The documentation process includes linking derivatives that are designated as fair value, cash flow, or net investment hedges to specific assets or liabilities on the balance sheet or to specific forecasted transactions. The Company also formally assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. In addition, certain hedging relationships are considered highly effective if the changes in the fair value or discounted cash flows of the hedging instrument are within a ratio of 80-125% of the inverse changes in the fair value or discounted cash flows of the hedged item. Hedge ineffectiveness is measured using qualitative and quantitative methods. Qualitative methods may include comparison of critical terms of the derivative to the hedged item. Depending on the hedging strategy, quantitative methods may include the "Change in Variable Cash Flows Method," the "Change in Fair Value Method," the "Hypothetical Derivative Method" or the "Dollar Offset Method."
The Company discontinues hedge accounting prospectively when: it determines that the derivative is no longer highly effective in offsetting changes in the fair value or cash flows of a hedged item; the derivative is dedesignated as a hedging instrument; or the derivative expires or is sold, terminated or exercised. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair-value hedge, the derivative continues to be carried at fair value on the balance sheets with changes in its fair value recognized in current period earnings through "net realized and unrealized gains and losses on derivative instruments." When hedge accounting is discontinued because the Company becomes aware that it is not probable that the forecasted transaction will occur, the derivative continues to be carried on the balance sheets at its fair value, and gains and losses that were accumulated in AOCI are recognized immediately in earnings.
The Company's indefinite-lived intangible assets consist primarily of Lloyd's syndicate capacity plus acquired insurance and reinsurance licenses. These assets are deemed to have indefinite useful lives and are therefore not subject to amortization. In accordance with GAAP, the Company tests non-amortized intangible assets for potential impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. If the carrying value of a non-amortized intangible asset is in excess of its fair value, the asset must be written down to its fair value through the recognition of an impairment charge to earnings.
The reserve for losses incurred but not reported is estimated by management based on loss development patterns determined by reference to the Company's underwriting practices, the policy form, type of program and historical experience. The Company's actuaries employ a variety of generally accepted methodologies to determine estimated ultimate loss reserves, including the "Bornhuetter-Ferguson incurred loss method" and frequency and severity approaches.
The Company records uncertain tax positions in accordance with ASC 740 on the basis of a two- step process in which (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon settlement with the tax authority.
The Company's investment income is allocated to applicable branch operations and is taxable in certain jurisdictions. The method of allocating this income may be different for tax reporting as compared to GAAP. The Company records the tax effects of this allocation entirely through operations.
Basic earnings per common share is based on weighted average common shares outstanding excluding any dilutive effects of potential share issuances under share-based compensation awards. Diluted earnings per common share assumes the exercise of all dilutive share-based compensation awards has occurred.
All excess tax benefits and tax deficiencies, including tax benefits of dividends on share-based payment awards, should be recognized as income tax expense or benefit (regardless of whether the benefit reduces taxes payable in the current period) in the income statement, as opposed to additional paid-in capital as previous GAAP prescribed. This amendment has been applied prospectively from January 1, 2017.
The threshold for share-based payment awards to qualify for equity classification now permits withholding up to maximum statutory tax rates in applicable jurisdictions, as opposed to employer minimum statutory withholding requirements in those jurisdictions. Adoption of this amendment had no impact on the Company's financial position.
Excess tax benefits now should be classified along with other income tax cash flows as an operating activity in the statement of cash flows. This amendment has been applied prospectively from January 1, 2017.
Companies may now make an entity-wide accounting policy election to either estimate the number of share-based payment awards expected to vest (in line with previous GAAP) or account for forfeitures as they occur. The Company elected not to change its previous accounting policy, and continues to measure the expense for share-based compensation based on the number of awards expected to vest.
In October 2016, the FASB issued an accounting standards update concerning the evaluation of indirect interests held through related parties during the assessment of variable interest entities ("VIEs"). When identifying the primary beneficiary of a VIE, this update requires a reporting entity that acts as the single decision maker of that VIE to include, on a proportionate basis, those interests held through related parties under common control when assessing whether it holds a variable interest in that VIE. This is a change from previous GAAP, which required such indirect interests to be included in their entirety during this assessment. In the event that a reporting entity is not considered to be the primary beneficiary of the VIE following this assessment, the update does not change the requirement to assess whether the entity and its related parties under common control as a group possess the characteristics of a primary beneficiary. The guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The amendments in this update were to be applied retrospectively to all periods since Accounting Standards Update 2015-02 was adopted, which for the Company was the first quarter of 2016. The Company adopted this guidance in 2017. There were no changes to the identified primary beneficiaries of any VIEs in which the Company holds an interest, and thus no impact on the Company's financial position, results of operations or cash flows.
ASU 2016-01 Recognition and Measurement of Financial Assets and Financial Liabilities
ASU 2016-16 Income Taxes: Intra-Entity Transfers of Assets Other Than Inventory
ASU 2017-07 Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost
In August 2017, the FASB issued an accounting standards update concerning hedge accounting. This update's targeted amendments to existing hedge accounting requirements better align an entity's risk management activities and financial reporting for hedging relationships via updates to both designation and measurement guidance for qualifying hedges, and the presentation of those results. Regarding designation and measurement, the amendments permit broader use of identified risk components in certain cash flow and fair value hedging relationships involving nonfinancial or interest rate risk. The range of permissible fair value hedges of interest rate risk was also increased. Regarding presentation, the amendments aim to align the recognition of the effects of hedging instruments with hedged items in the financial statements in order to increase the understandability of an entity's intended hedging strategies. As a result, "hedge ineffectiveness" will no longer be separately measured and reported. The entire change in the fair value of a qualifying hedging instrument included in the assessment of hedge effectiveness is either presented in the same income statement line as the hedged item for fair value hedges, or in other comprehensive income for cash flow and net investment hedges. However, in limited situations, certain components of a hedging instrument's change in fair value may be excluded from the assessment of hedge effectiveness.
ASU 2018-02 Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
On October 11, 2016, Fundamental Insurance Investment Ltd ("FII"), an indirect wholly-owned subsidiary of the Company, completed a partial sale, to an unrelated investor, of its common and preference shares in New Ocean Capital Management Limited ("New Ocean"), an entity in which it holds a majority voting interest.
XL America and XLLAHC received a closing date payment of $20.9 million in proceeds from the transaction, which was based upon the fair market value of XLLIAC's investment assets and insurance licenses. The Company recorded a pre-tax gain of $3.7 million as a result of this transaction.
The purchase price was allocated to the acquired assets and assumed liabilities of Allied based on estimated fair values on the acquisition date. The estimated fair value of the net assets acquired and liabilities assumed was $76.7 million, which includes indefinite-lived intangible assets of $8.0 million and definite-lived intangible assets of $6.0 million, which will be amortized over their estimated useful lives. Other adjustments to the historical carrying value of acquired assets and liabilities included: the estimated fair value of net loss and loss expense reserves at the present value of expected net loss and loss adjustment expense payments plus a risk premium, the estimated value of the business acquired at the present value of expected underwriting profits with net unearned premiums plus a risk margin less policy servicing costs, and the estimated fair value of real estate assets at appraised market values. In conjunction with the transaction, the Company recognized goodwill of $14.1 million, which is primarily attributable to Allied's underwriting expertise in a niche specialty risk business. The Company allocated all of the $14.1 million of goodwill to its Insurance segment. See Note 9, "Goodwill and Other Intangible Assets," for further information.
On May 1, 2015 (the "Acquisition Date"), XL-Ireland completed the Catlin Acquisition for $4.1 billion.
The Company financed the $2.29 billion cash portion of the Acquisition Consideration by issuing $1.0 billion of subordinated debt, the proceeds (net of debt issuance costs) of which were $980.6 million, and the remaining $1.31 billion by using cash and cash equivalents on hand. See Note 14, "Notes Payable and Debt and Financing Arrangements," for further information on the debt issuance.
The following table summarizes the financial results of the acquired Catlin subsidiaries from the Acquisition Date through the end of 2015 that have been included within the Company's Consolidated Statements of Income and Consolidated Statements of Comprehensive Income as required by ASC 805-10-50-2(h) based on legal entity reporting. These results were not used as a part of management analysis of the financial results and performance of the Company's business. These results are adjusted, where possible, for transaction and integration related costs. These results involve a significant amount of estimates and are not indicative of future results of the acquired Catlin subsidiaries, which were further impacted by potential changes in targeted business mix, investment management strategies, and synergies recognized from changes in the combined entity's operating structure, as well as the impact of changes in other business and capital management strategies.
After the Acquisition Date, underlying policies have been underwritten onto different legal entities, staffing has been allocated to new divisions and activities, and reinsurance has been purchased to cover combined risks, only some of which would have been reflected in the underlying legacy Catlin infrastructure, systems and general ledgers of the acquired Catlin subsidiaries.
Operating expenses of the segments exclude Corporate operating expenses, shown separately.
The net results from P&C structured products include net investment income and interest expense of $51.7 million and $25.3 million, respectively.
Net fee income and other includes operating expenses of $50.7 million from the Company's loss prevention consulting services business.
The net results from P&C structured products include net investment income and interest expense of $54.0 million and $39.7 million, respectively.
Net fee income and other includes operating expenses of $46.6 million from the Company's loss prevention consulting services business.
The following tables summarize the Company's net premiums earned by line of business:
Amounts from the prior year have been re-presented to reflect current mapping of underlying lines of business to be consistent with the manner in which they are reflected in the current period. The most significant movements include movements of certain items out of Other as follows: Programs business is now reflected in Property or Casualty, depending upon the predominant line for each program; Surplus lines is now reflected primarily in Casualty and Property; and Accident & Health is now reflected in Specialty.
The cost (amortized cost for fixed maturities and short-term investments), fair value, gross unrealized gains and gross unrealized (losses), including non-credit related OTTI recorded in AOCI of the Company's AFS investments at December 31, 2017 and 2016 were as follows:
The amortized cost and fair value of trading investments at December 31, 2017 and 2016 were as follows:
At December 31, 2017 and 2016, approximately 3.3% and 2.5%, respectively, of the Company's fixed income investment portfolio at fair value, excluding Life Funds Withheld Assets, was invested in securities that were below investment grade or not rated. Approximately 4.2% and 4.1% of the gross unrealized losses in the Company's fixed income investment portfolio, excluding cash and Life Funds Withheld Assets, at December 31, 2017 and 2016, respectively, related to securities that were below investment grade or not rated.
The following is an analysis of how long the AFS securities at December 31, 2017 and 2016 had been in a continual unrealized loss position:
Net investment income for the years ended December 31, 2017, 2016 and 2015 is derived from the following sources:
The components of OTTI charges for the years ended December 31, 2017, 2016 and 2015, as defined in Note 1(g), "Significant Accounting Policies - Other-Than-Temporary Impairments of Available for Sale," for investments excluding Life Funds Withheld Assets were:
The following table sets forth the amount of credit loss impairments on fixed income securities, for which a portion of the OTTI loss was recognized in Other Comprehensive Income ("OCI"), held by the Company at December 31, 2017, 2016 and 2015 and the corresponding changes in such amounts.
Investments in affiliates comprised the following at December 31, 2017 and 2016:
See Note 1(c), "Significant Accounting Policies - Investments - Investments in Affiliates," for a description of our accounting policy for these assets
The Company has invested in certain hedge funds, including funds managed by certain of its investment manager affiliates, and in certain private equity investments and private credit funds (collectively, "private investments") that are accounted for under the equity method due to our ownership percentages in the limited partnerships, LLCs or other similar investment vehicles that form the funds. Collectively, these investments in hedge funds and private investments are classified as "investment affiliates." At December 31, 2017 and 2016, the hedge fund portfolio, accounted for as hedge fund affiliates, employed four strategies: arbitrage, directional, event driven and multi-style.
Total estimated net assets are generally as at November 30 for hedge fund affiliates and September 30 for private investment affiliates.
The Company accounts for its investment in certain funds using the equity method where the Company has significant influence over the related investment management company.
The carrying value of the Company's holdings in hedge fund affiliates that are subject to lockups and/or that have redemption gate provisions in their governing documents at December 31, 2017 and 2016 was $222.7 million and $553.2 million, respectively.
Certain hedge funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity or private debt. In such cases, a common mechanism used is a side-pocket, whereby the illiquid security is assigned to a separate memorandum capital account or other designated account. Typically, the investor loses its redemption rights in the designated account. Only when the illiquid securities in the side-pocket are sold, or otherwise deemed liquid by the fund, may investors redeem that portion of their interest that has been "side-pocketed." At December 31, 2017 and 2016, the carrying value of our hedge fund affiliates held in side-pockets was $20.1 million and $23.5 million, respectively. The underlying assets within these positions are generally expected to be liquidated over a period of approximately two to four years.
The Company has invested in securities or other forms of direct ownership interests across the capital structure of strategic (re)insurance affiliates, investment management company affiliates, and other strategic and operating affiliates. Collectively, these investments are classified as "operating affiliates."
During the years ended December 31, 2017 and 2016, the Company received distributions from its Investment Manager Affiliates of approximately $32.1 million and $35.9 million, respectively.
In certain investments, the carrying value is different from the share of the investee's underlying net assets. The differences represent goodwill on acquisition, OTTI recorded with respect to the investment, or differences in the retained capital accounts of the various equity holders (including the Company).
At December 31, 2017, the Company's most significant investment manager affiliate is Highfields Capital, a global equity investment firm.
The Company also has an investment of $40.0 million, representing a 20.0% ownership interest in Mahindra Insurance Brokers Limited.
On April 1, 2015, the Company completed the sale of its interests in one of its largest strategic and other operating affiliates, ARX, to Progressive. For further information, see Note 2(g), "Acquisitions and Disposals - Sale of Operating Affiliate."
Other investments comprised the following at December 31, 2017 and 2016. See Note 1(c), "Significant Accounting Policies - Investments - Other Investments," for a description of our accounting policy for these assets:
Certain hedge funds have a lock-up period and/or may also have the ability to impose a redemption gate as noted in Note 5, "Investments in Affiliates." The fair value of the Company's holdings in hedge funds that are subject to lockups and/or that have redemption gate provisions in their governing documents at December 31, 2017 and 2016 was $178.0 million and $223.3 million, respectively. The Company did not have any holdings in funds where a redemption gate was imposed at December 31, 2017 or 2016.
Certain hedge funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity or private debt, as noted in Note 5, "Investments in Affiliates." At December 31, 2017 and 2016, the fair value of hedge funds held in side-pockets was $9.2 million and $11.3 million, respectively. The underlying assets within these positions are generally expected to be liquidated over a period of approximately two to four years.
In connection with the Facility, XLIB purchased a payment obligation (the "Obligation") in an aggregate principal amount of $150.0 million from National Indemnity. At December 31, 2017, the outstanding Obligation was recorded in other investments at a carrying value of $142.8 million, pays a coupon of 3.5%, and is being accreted to $150.0 million over the 11.5 years term of the payment obligation. The difference between the estimated fair value of the Obligation and the cost of that Obligation at the time of the transaction was approximately $21.9 million and was recorded in Other Assets. This difference, together with fees of $2.5 million, was amortized in relation to the earning of the underlying policies written.
The Company enters into derivative instruments for both risk management and investment purposes. The Company is exposed to potential loss from various market risks, and manages its market risks based on a comprehensive framework of investment decision authorities ("Authorities Framework") adopted by the Risk and Finance Committee of XL Group's Board of Directors ("RFC"). The Authorities Framework is intended to align the risk profile of our investment portfolio to be consistent with the Company's risk tolerance and other guidelines established by the RFC. The following table summarizes information on the notional amounts and gross amounts of derivative fair values contained in the Consolidated Balance Sheets at December 31, 2017 and 2016:
At December 31, 2017, the Company held cash collateral related to foreign currency derivative positions and certain other derivative positions of $3.9 million for derivatives in an asset position and paid cash collateral of $1.3 million for derivatives in a liability position. At December 31, 2016, the Company held cash collateral related to a foreign currency derivative position and certain other derivative positions of $37.0 million for derivatives in an asset position and paid cash collateral of $5.8 million for derivatives in a liability position. The assets and liabilities related to the net collateral paid or held were recorded as Other assets and Other liabilities within the Consolidated Balance Sheets as the collateral and derivative positions are not intended to be settled on a net basis.
Derivative instruments in an asset or liability position are included within "Other assets" or "Other liabilities", respectively, at fair value in the Consolidated Balance Sheets on a net basis where the Company has both a legal right of offset and the intention to settle the contracts on a net basis. Certain embedded derivatives within reinsurance contracts are included in "Reinsurance balances payable." The Company often enters into different types of derivative contracts with a single counterparty, and these contracts are covered under netting agreements. Changes in the fair values of derivatives are shown in the Consolidated Statements of Income as "Net realized and unrealized gains (losses) on derivative instruments," unless the derivatives are designated as hedging instruments. The accounting for derivatives that are designated as hedging instruments is described in Note 1(h), "Significant Accounting Policies - Derivative Instruments."
The Company utilizes foreign currency contracts to hedge the fair value of certain net investments in foreign operations. During the years ended December 31, 2017, 2016 and 2015, the Company entered into foreign currency contracts that were formally designated as hedges of investments in foreign subsidiaries, the majority of which have functional currencies of either the British pound or the Euro. There was no ineffectiveness in these transactions.
The following table provides the weighted average U.S. dollar equivalent of foreign denominated net assets that were hedged and the resulting derivative gain (loss) that was recorded in the foreign currency translation adjustment, net of tax, account within AOCI for the years ended December 31, 2017, 2016 and 2015.
The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. The Company uses foreign currency contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equities. 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.
Credit derivatives may be purchased within the Company's investment portfolio in the form of single name and basket credit default swaps and swaptions, which are used to mitigate credit exposure through a reduction in credit spread duration (i.e., macro credit strategies rather than single-name credit hedging) or exposure to securities of selected issuers. Credit derivatives may also be used to efficiently gain exposure to credit markets, subject to guidelines that prohibit the introduction of effective leverage.
In the fourth quarter of 2017, the Company entered into an average rate option to mitigate the risk of foreign currency exposure to certain cash flows denominated in the British pound. The option will mature in the fourth quarter of 2018. In the prior year, the Company entered into a similar average rate option.
During the year ended December 31, 2017, the Company entered into a non-investment-related credit derivative relating to a number of reference pool mortgage tranches associated with actual mortgage loans that were securitized into agency mortgage-backed securities and sold as Structured Agency Credit Risk Notes. At December 31, 2017, there was no reported event of default on this obligation. The credit derivative is recorded at fair value based upon models developed by the Company. Significant unobservable inputs considered in the valuation include the impact of changes in interest rates, future defaults, delinquency and prepayment rates, credit spreads, changes in credit quality, and other market factors.
The Company has derivatives embedded in certain reinsurance contracts. For a certain life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of the guaranteed benefit 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.
Modified Coinsurance and Funds Withheld Contracts, including Life Retrocession Embedded Derivative
The Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return to be paid based on a portfolio of fixed income securities. As such, the agreements contain an embedded derivative. 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 (losses) on derivative instruments."
In addition, the Company entered into the GreyCastle Life Retro Arrangements as described in Note 1(c), "Significant Accounting Policies - Investments - Investments Related to Life Retrocession Arrangements written on a Funds Withheld Basis," "Note 1(e), "Significant Accounting Policies - Reinsurance," and Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation." The embedded derivative related to the GreyCastle Life Retro Arrangements is recorded at fair value with changes in fair value recognized in earnings through "Net realized and unrealized gains (losses) on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets."
The Company has entered into short term weather derivative swap agreements as the fixed rate payer which provide for a return to be paid to the Company based on the occurrence of certain industry weather events. The derivatives are recorded at fair value with changes in fair value recognized in earnings through "Net realized and unrealized gains (losses) on derivative instruments."
During the fourth quarter of 2010 and the third quarter of 2012, the Company settled five interest rate contracts designated as fair value hedges of certain of the Company's structured indemnity contracts. The gain on settlement of these contracts, which represented the effective portion of the hedging relationship, was recorded as an increase in the carrying value of the
A summary of the fair value hedges that have been settled and their impact on results up to the indicated periods, as well as the remaining balance of the fair value hedges and average years remaining to maturity at December 31, 2017 and 2016 are shown below:
Certain derivative agreements entered into by the Company or its subsidiaries contain credit rating downgrade provisions that permit early termination of the agreements by the counterparty if collateral is not posted following failure to maintain certain credit ratings from one or more of the principal credit rating agencies. If the Company were required to terminate such agreements early due to a credit rating downgrade, it could potentially be in a net liability position at the time of settlement of such agreements. The aggregate fair value of all derivative agreements containing such rating downgrade provisions that were in a liability position and any collateral posted under these agreements as of December 31, 2017 and 2016 were as follows:
The following tables set forth the Company's assets and liabilities that were accounted for at fair value at December 31, 2017 and 2016 by level within the fair value hierarchy. For further information, see Note 1(b), "Significant Accounting Policies - Fair Value Measurements":
Other assets and other liabilities include derivative instruments. The derivative balances included in each category are reported gross of cash collateral by level with a counterparty netting adjustment presented separately in the Counterparty Netting column. The fair values of the individual derivative contracts are reported gross in their respective levels based on the fair value hierarchy. For further details regarding derivative fair values and associated collateral received or paid, see Note 7, "Derivative Instruments."
Transaction activity inputs utilized in the valuation of fair value hierarchy Level 2 securities within these sub-categories include actual trades, dealer posts, results of bids-wanted, institutional secondary offerings, primary market offerings and Trade Reporting and Compliance Engine ("TRACE") trade feeds. As part of the evaluation process, transaction activity is compared to prior evaluations and necessary adjustments are made accordingly. Market-color inputs include actively quoted benchmark issues, buy-side/evaluator dialogue, sell-side/evaluator dialogue and credit derivative indices.
Transaction activity inputs utilized in the valuation of fair value hierarchy Level 2 securities within this sub-category include actual trades, dealer posts, results of bids-wanted, institutional secondary offerings, primary market offerings, and Municipal Securities Rulemaking trade feeds. As part of the evaluation process, transaction activity is compared to prior evaluations and necessary adjustments are made accordingly. Market-color inputs include bids, offerings, two-sided markets, buy-side/evaluator dialogue and sell-side/evaluator dialogue. Credit information inputs include issuer financial statements, default and material event notices, developer reports and liquidation and restructuring analyses.
Other assets and other liabilities primarily include over-the-counter ("OTC") derivatives, which are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative independent pricing sources where an understanding of the inputs utilized in arriving at the valuations is obtained. Where models are used, the selection of a particular model to value an OTC derivative depends upon the contractual terms and specific risks inherent in the instrument as well as the availability of pricing information in the market. The Company generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, interest rate swaps and options, model inputs can generally be verified against observable inputs and model selection does not involve significant management judgment.
The calculation of the change in fair value of the embedded derivative associated with the GreyCastle Life Retro Arrangements includes the interest income, realized and unrealized gains and losses on Life Funds Withheld Assets and certain expenses related to the Life Funds Withheld Assets. The fair value of the embedded derivative is included in "Funds withheld on GreyCastle life retrocession arrangements, net of future policy benefit reserves recoverable" on the Consolidated Balance Sheets. The fair value of the embedded derivative is considered a Level 2 valuation.
There were no significant transfers between Level 1 and Level 2 during each of the years ended December 31, 2017 and 2016.
balances for the years ended December 31, 2017 and 2016 for all financial assets and liabilities measured at fair value using significant unobservable inputs (Level 3) at December 31, 2017 and 2016, respectively. The tables do not include gains or losses that were reported in Level 3 in prior periods for assets that were transferred out of Level 3 prior to December 31, 2017 and 2016, respectively. Gains and losses for assets and liabilities classified within Level 3 in the table below may include changes in fair value that are attributable to both observable inputs (Levels 1 and 2) and unobservable inputs (Level 3). Further, it should be noted that the following tables do not take into consideration the effect of offsetting Level 1 and 2 financial instruments entered into by the Company that are either economically hedged by certain exposures to the Level 3 positions or that hedge the exposures in Level 3 positions.
The remainder of the Level 3 assets relate primarily to private investments (including funds) and certain derivative positions as described below.
Included within the other investments component of the Company's Level 3 valuations are private investments (including funds) and hedge funds where the Company is not deemed to have significant influence over the investee. The fair value of these investments is based upon net asset values received from the investment manager or general partner of the respective entity. The underlying investments held by the investee that form the basis of the net asset value include assets such as private business ventures and are such that significant Level 3 inputs are utilized in the determination of the individual underlying holding values. Accordingly, the fair value of the Company's investment in each entity is classified within Level 3. Management reviews the values and incorporates factors such as the most recent financial information received, annual audited financial statements and the values at which capital transactions with the investee take place when applying judgment regarding whether any adjustments should be made to the net asset value received in recording the fair value of each position. Investments in hedge funds included in other investments utilize strategies including arbitrage, directional, event driven and multi-style. The funds potentially have lockup and gate provisions which may limit redemption liquidity. For further details regarding the nature of other investments and related features, see Note 6, "Other Investments."
Derivative instruments recorded within other liabilities and classified within Level 3 include: credit derivatives sold providing protection on senior tranches of structured finance transactions where the value is obtained directly from the investment bank counterparty and sufficient information regarding the inputs utilized in such valuation was not obtained to support a Level 2 classification, and guaranteed minimum income benefits embedded within one reinsurance contract. The majority of inputs utilized in the valuations of these types of derivative contracts are considered Level 1 or Level 2; however, each valuation includes at least one Level 3 input that was significant to the valuation and, accordingly, the values are disclosed within Level 3.
Net transfers include both movement in and movement out of Level 3. Corporate for 2017 includes incoming transfers of $1.4 million partially offset by $0.1 million of outgoing transfers. RMBS for 2017 includes incoming transfers $4.1 million partially offset by $3.4 million of outgoing transfers. Other asset-backed securities for 2017 includes outgoing transfers of $25.4 million partially offset by $12.0 million of incoming transfers. Corporate for 2016 includes outgoing transfers of $12.2 million partially offset by $9.7 million of incoming transfers. Other asset-backed securities for 2016 includes outgoing transfers $21.4 million partially offset by $3.0 million of incoming transfers. Other investments for 2016 includes $77.7 million of outgoing transfers partially offset by 15.5 million of incoming transfers.
The Company historically participated in structured transactions, the remaining of which are largely comprised of an investment in a payment obligation with an insurance company. This transaction is carried at amortized cost. The fair value of this investment held by the Company is determined through use of an internal model utilizing benchmark yields, issuer spreads and reference data.
Deposit liabilities include obligations under structured insurance and reinsurance transactions. For purposes of fair value disclosures, the Company determined the estimated fair value of the deposit liabilities by assuming a discount rate equal to the appropriate U.S. Treasury rate plus 45.5 basis points and 50.0 basis points at December 31, 2017 and 2016, respectively. The discount rate incorporates the Company's own credit risk into the determination of estimated fair value.
At December 31, 2017 and 2016, the Company had goodwill of $1.2 billion, with $492.3 million and $483.6 million, respectively allocated to the Insurance Segment and $741.9 million and $730.0 million, respectively, allocated to the Reinsurance Segment.
In February 2016, as a result of the transaction described in Note 2(d), "Acquisitions and Disposals - Allied Acquisition," the Company recognized goodwill of approximately $14.1 million. The transaction was accounted for using the acquisition method under which the Company recorded the identifiable assets acquired, including indefinite-lived and definite-lived intangible assets, and liabilities assumed, at their acquisition date fair values, and recorded the excess of consideration transferred over the net assets acquired as goodwill.
In May 2015, as a result of the transaction described in Note 2(f), "Acquisitions and Disposals - Catlin Acquisition," the Company recognized additional goodwill and other intangible assets. The transaction was accounted for using the acquisition method under which the Company recorded the identifiable assets acquired, including indefinite-lived and definite-lived
The estimated fair values of the reporting units' goodwill exceeded their estimated net book values at December 31, 2017, and therefore no impairments were recorded during 2017. At December 31, 2017 and 2016, the ending goodwill balance is comprised of gross goodwill of $2.6 billion, offset by accumulated impairment charges of $1.4 billion at December 31, 2017 and 2016. For further details regarding our impairment process, see Note 1(k), "Significant Accounting Policies - Goodwill, Intangibles and Other Long-Lived Assets."
In connection with the transaction described in Note 2(c), "Acquisitions and Disposals - Brooklyn Acquisition," the Company acquired definite-lived intangible assets of $22.9 million, which will be amortized over their estimated useful lives.
The following table represents a reconciliation of the beginning and ending balances of unpaid losses and loss expenses, including an analysis of the Company's paid and unpaid losses and loss expenses incurred for the years indicated:
P&C business only, net of provision for uncollectible reinsurance. See Note 12, "Reinsurance," for further information.
Since the Company relies on information regarding paid losses, case reserves and IBNR provided by ceding companies to estimate its liability for unpaid losses and loss adjustment expenses ("LAE"), certain procedures are maintained in order to help determine the completeness and accuracy of such information. Periodically, management assesses the reporting activities of its ceding companies on the basis of qualitative and quantitative criteria. In addition to conferring with ceding companies or brokers on claims matters, our claims personnel conduct periodic audits of specific claims and the overall claims procedures of ceding companies at their offices. The Company relies on its ability to effectively monitor the claims handling and claims reserving practices of ceding companies in order to help establish the proper reinsurance premium for reinsurance agreements and to establish proper loss reserves. Disputes with ceding companies have been rare and generally have been resolved through negotiation.
While the reliance on loss reports from ceding companies may increase the level of uncertainty associated with the estimation of total loss reserves for property catastrophe reinsurance relative to direct property insurance, there are several factors which serve to reduce the uncertainty in loss reserve estimates for property catastrophe reinsurance. First, for large natural catastrophe events, aggregate limits in property catastrophe reinsurance contracts are in some cases fully exhausted by the loss reserve estimates. Second, as a reinsurer, the Company has access to information from a broad cross section of the insurance industry. The Company utilizes such information in order to perform consistency checks on the data provided by ceding companies and is able to identify trends in loss reporting and settlement activity and incorporate such information in the
The Company's actuaries use one set of assumptions in calculating the single point estimate, which includes actual loss data, loss development factors, loss ratios, reported claim frequency and severity. The actuarial reviews and documentation are completed in accordance with professional actuarial standards with reserves established on a basis consistent with GAAP. The selected assumptions reflect the actuary's judgment based on historical data and experience combined with information concerning current underwriting, economic, judicial, regulatory and other influences on ultimate claim settlements.
When estimating IBNR reserves, each insurance and reinsurance business unit segregates business into exposure classes. Within each class, the business is further segregated by either the year in which the contract incepted ("underwriting year"), the year in which the claim occurred ("accident year"), or the year in which the claim is reported ("report year"). Within the Insurance segment, reviews are on an accident year, underwriting year, or report year basis depending on the nature of the business. The Reinsurance segment is reviewed on an underwriting year basis. In each case, management believes the selected method represents an appropriate basis for evaluating the reserve associated with each.
Due to the low frequency and high severity nature of some of the business the Company underwrites, our reserve estimates are highly dependent on actuarial and management judgment and are therefore uncertain. In property classes, there can be additional uncertainty in loss estimation related to large catastrophe events. With wind events, such as hurricanes, the damage assessment process may take more than a year. The cost of claims is subject to volatility due to supply shortages for construction materials and labor. In the case of earthquakes, the damage assessment process may take several years as buildings are discovered to have structural weaknesses not initially detected. The uncertainty inherent in IBNR reserve estimates is particularly pronounced for casualty coverages, such as excess liability, professional liability and workers' compensation, where information emerges relatively slowly over time.
The three types of property and casualty reserve exposures with the longest tails included in the Company's portfolio are:
High layer excess casualty insurance claims typically involve claims relating to (i) a "shock loss" such as an explosion or transportation accident causing severe damage to persons and/or property over a short period of time, (ii) a "non-shock" loss where a large number of claimants are exposed to injurious conditions over a longer period of time, such as exposure to chemicals or pharmaceuticals or (iii) a professional liability loss such as a medical malpractice claim. In each case, these claims are ultimately settled following extensive negotiations and legal proceedings. This process typically takes 5 to 15 years following the date of loss.
Reinsurance operations by their nature add further complications to the reserving process, particularly for the casualty business written, in that there is an inherent lag in the timing and reporting of a loss event from an insured or ceding company to the reinsurer. This reporting lag creates an even longer period of time between the policy inception and when a claim is finally settled. As a result, more judgment is required to establish reserves for ultimate claims in reinsurance operations.
Casualty reinsurance business involves reserving methods that generally include historical aggregated claim information as reported by ceding companies, combined with the results of claims and underwriting reviews of a sample of the ceding company's claims and underwriting files. Therefore, we do not always receive detailed claim information for this line of business.
Discontinued asbestos and run-off environmental liabilities are attached to certain policies previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to being acquired by the Company; from business of Winterthur purchased by the Company from AXA Insurance in 2001; from a loss portfolio transfer in 2006; and acquired as a result of the Catlin Acquisition. At December 31, 2017, total gross unpaid losses and loss expenses with respect to these businesses represented less than 1% of unpaid losses and loss expenses of the Company.
Management has determined that the appropriate level of disaggregation for the incurred and paid claims development information best falls into six categories within its two operating segments. This level of disaggregation is consistent with the Company's historical disclosure levels and provides groupings of the Company's insurance and reinsurance businesses of a credible size and with similar claim development characteristics, particularly payment patterns. It should be noted that when estimating IBNR reserves, the Company's Insurance and Reinsurance segments segregate business into exposure classes and a large number of classes are reviewed in total based on coverage, region and policy and loss emergence characteristics. Furthermore, large losses and catastrophe events are evaluated separately.
The Company has also revalued all historical data using exchange rates at December 31, 2017 in order to mitigate the effect of foreign exchange on the development throughout the triangles. Due to currency mix changes from one year end to the next, revaluation of incurred losses will result in different year-on-year movements within the triangles with each annual presentation. This approach for handling foreign exchange movements within the triangles differs somewhat from the
The Average Annual Percentage Payout of Incurred Losses for each age has been derived using a weighted average of all cumulative paid amounts as a percentage of 2017 incurred losses and allocated loss expenses. The average annual percentage payout of incurred losses presented are unaudited and are presented as supplementary information. The average annual percentage payout can change over time due to changes in business mix, policy terms and conditions as well as ceded reinsurance arrangements. As an example, due to a large multi-line quota share contract and multi-year non-standard auto deals written in the more recent years and included within our Reinsurance Casualty and Other Long-Tail portfolio, there is an upward trend in average annual percentage payout observed from last year.
For the Insurance segment in total, while individual accident years have both favorable and adverse incremental development across the triangle, accident years 2008 to 2013 have all developed favorably since the first evaluation. The 2014 to 2016 accident years reflect adverse development due primarily to large loss activity in several lines, including professional and casualty.
For the Insurance Specialty category, individual accident years have generally developed favorably, though with decreasing magnitude over time. The adverse experience emerging on the 2016 accident year has been driven by unfavorable attritional and large claims experience in several portfolios. This category includes a range of businesses with both short-tail and medium-tail exposures. Typically, development in the second year relates to short-tail lines with development on medium-tail business being reflected at subsequent evaluations.
The following table presents the net (favorable) adverse prior year loss development of the Company's loss and loss expense reserves for its property and casualty operations by operating segment for each of the years indicated:
The significant developments in prior year loss reserve estimates for each of the years indicated within the Company's Insurance and Reinsurance segments are discussed below.
The following table summarizes the net (favorable) adverse prior year development by business group relating to the Insurance segment for the years ended December 31, 2017, 2016 and 2015:
For property lines, net prior year development was $96.4 million unfavorable. This was driven by adverse attritional loss experience on the 2015 and 2016 underwriting years within the London wholesale property book, which led to strengthening of $62.2 million. In addition, significant large loss experience primarily on 2016 losses on the energy property book resulted in strengthening of $39.9 million.
For specialty lines, net prior year development was $4.5 million favorable. This was driven by better than expected attritional loss experience in aerospace. This was partially offset by worse than expected large loss experience in more recent years in the crisis management and political risk & trade credit portfolios.
For professional lines, net prior year development was $9.6 million favorable. This was driven by releases of favorable experience in the core standard commercial portfolio in North America on the 2014 and prior exposure years. This was partially offset by strengthening in the professional select miscellaneous error and omissions portfolio and by strengthening in the international financial lines management liability book due to significant large loss experience primarily in 2014 and 2015 exposure years.
For casualty and other lines, net prior year development was $124.1 million favorable. This was driven by consistent benign experience on a mature North America casualty portfolio resulting in releases of $64.7 million, as well as reductions to reflect better than expected loss experience reported on North America construction and global risk management. This was partially offset by strengthening to reflect worse than expected loss experience reported on the excess and surplus business.
Net favorable prior year reserve development totaled $65.0 million for the Insurance segment for the year ended December 31, 2015. Specialty benefited from releases in marine, the discontinued international political risk portfolio due to a
favorable settlement of a loss on the 2009 accident year, and reductions in the discontinued specialty book. Casualty was
subject to adverse development with deteriorations in excess and surplus and a large claim in the surety portfolio partially offset
in the core U.S. standard commercial book and select accountants and public entities portfolios led to overall adverse
Net favorable prior year reserve development for the year ended December 31, 2017 totaled $106.0 million for the Reinsurance segment. This amount differs from the implied change in ultimate losses that can be calculated from the above triangles because the triangles exclude accident years prior to 2007 as well as minor business and, as noted earlier, utilize a different approach for handling foreign exchange. The total net prior year development of $106.0 million was attributable to the following:
For property catastrophe lines, net prior year development was $63.0 million favorable. This was mainly to releases from our reserves for older catastrophes losses and better than expected experience on attritional losses.
Net favorable prior year reserve development totaled $210.1 million for the year ended December 31, 2016. The short-tail lines benefited from $25.6 million in favorable development from property other lines, $76.6 million favorable development in property catastrophe lines and $32.2 million in favorable development within specialty lines. The release in long tail lines was due to favorable development of $65.5 million and $10.0 million in casualty and other, respectively.
Net favorable prior year reserve development totaled $241.6 million for the year ended December 31, 2015. The short-tail lines benefited from $88.9 million in favorable development from property other lines, $50.3 million favorable development in property catastrophe lines and $34.6 million in favorable marine and aviation development. The release in long-tail lines was due to favorable development of $40.1 million and $27.8 million in casualty and other, respectively.
The Company utilizes tabular reserving for workers' compensation (including long-term disability) unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 3.75% in 2017 and 2016. The interest rate approximates the implied return on the market-based assets supporting the expected cash flows of our liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment
The Company's reserving process includes a continuing evaluation of the potential impact on unpaid liabilities from exposure to discontinued asbestos and run-off environmental related claims, including related loss adjustment expenses. Liabilities are established to cover both known and incurred but not reported claims. The Company's reserving and exposures to environmental liability business currently written within the Casualty underwriting division are not included in this note, which only relates to specific discontinued and/or run-off coverages that were not originally written specifically to cover environmental hazards.
The Company's exposure to discontinued asbestos and run-off environmental related claims arises from the following four sources:
Reserves for incurred but not reported losses, net of reinsurance, included in the above table were $51.3 million, $60.3 million and $65.1 million at December 31, 2017, 2016 and 2015, respectively. Unpaid losses recoverable are net of potential uncollectible amounts.
At December 31, 2017, the Company had 2,176 open claim files for potential discontinued asbestos claims exposures and 435 open claim files for potential run-off environmental claims exposures. Approximately 37%, 34% and 32% of the open claim files are due to precautionary claim notices in 2017, 2016 and 2015, respectively. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The increase in total open claim files during 2015 was largely due to the Catlin Acquisition, as noted above.
The estimation of loss and loss expense liabilities for discontinued asbestos and run-off environmental exposures is subject to much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: (i) uncertain legal interpretations and application of insurance and reinsurance coverage and liability; (ii) the lack of reliable available historical claims data as an indicator of future claims development; (iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and (iv) the potential of insurers and reinsurers to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of loss and loss expense liabilities beyond recorded reserves can be established. As the Company's net unpaid loss and loss expense reserves related to discontinued asbestos and run-off environmental exposures are less than 1% of the total net reserves at December 31, 2017 and 2016, further adverse development is not expected to be material to the Company's overall net loss reserves. The Company believes it has made
reasonable provisions for its discontinued asbestos and run-off environmental exposures and is unaware of any specific issues that would significantly affect its estimate of loss and loss expenses.
The Company entered into long duration contracts that subject the Company to mortality and morbidity risks and that were accounted for as life premiums earned. Future policy benefit reserves were established using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The average interest rate used for the determination of the future policy benefits for these contracts was 4.0% at December 31, 2017 and 2016.
Under the terms of the transaction described in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," the Company has reinsured $3.2 billion and $3.1 billion at December 31, 2017 and 2016, respectively, of its future policy benefit reserves under the GreyCastle Life Retro Arrangements. The Company continues to own, on a funds withheld basis, assets supporting the GreyCastle Life Retro Arrangements consisting of cash, fixed maturity securities and accrued interest. Based upon the contractual right of offset, the funds withheld liability owing to GCLR is recorded net of future policy benefit reserves recoverable, and is included within "Funds withheld on GreyCastle life retrocession arrangements (net of future policy benefit reserves recoverable)" on the Consolidated Balance Sheets, and is comprised of the following at December 31, 2017 and 2016:
The table above excludes a combined $3.2 billion and $0.2 billion of the Company's future policy benefit reserve recoverables under the GreyCastle Life Retro Arrangements and U.S. Term Life Retro Arrangements, as defined in Note 11, "Future Policy Benefit Reserves," respectively, and are also excluded from the remainder of this disclosure.
The Company uses an aging analysis to estimate uncollectible reinsurance balances receivable relating to paid losses in addition to recording allowances relating to any specific balances with known collectibility issues, irrespective of aging. The balances are aged from the date the expected recovery was billed to the reinsurer. Provisions are applied at specified percentages of the outstanding balances based upon the aging profile. Allowances otherwise required as a result of the aging process may not be recorded to the extent that specific facts and circumstances exist that lead management to believe that amounts will ultimately be collectible.
The Company has entered into certain insurance and reinsurance policies that transfer insufficient risk under GAAP to be accounted for as insurance or reinsurance transactions and are recognized as deposits. These structured P&C agreements have been recorded as deposit liabilities and are initially matched by an equivalent amount of investments. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the ultimate liability. See Note 4, "Investments," for further information relating to the Company's net investment income as well as realized and unrealized investment (losses) gains. Each deposit liability accrues at a rate equal to the internal rate of return of the payment receipts and obligations due during the life of the agreement. Where the timing and/or amount of future payments are uncertain, cash flows reflecting the Company's actuarially determined best estimates are utilized. Deposit liabilities are initially recorded at an amount equal to the assets received.
The following table presents the Company's outstanding notes payable and debt as of December 31, 2017 and 2016:
(1) "Outstanding" data represent December 31, 2017 and December 31, 2016 accreted values.
This issuance carried a fixed coupon of 3.25% for a period of ten years, then a floating rate of three-month EURIBOR plus 2.90% from (and including) June 29, 2027 through maturity. The outstanding amount is subject to movement due to foreign exchange.
All outstanding debt of the Company at December 31, 2017 and 2016, which is identified in the table above, was issued by XLIT. XLIT's outstanding debt, other than the Senior Notes due 2024 and due 2027, are listed on the NYSE and are fully and unconditionally guaranteed by XL Group. See Note 26, "Guarantor Financial Information," for condensed comparative financial information of XL Group and XLIT for the periods ended December 31, 2017 and December 31, 2016.
On March 30, 2015, XLIT issued $500 million of subordinated notes due March 2025, with a fixed coupon of 4.45%, at 99.633% of the face amount and net proceeds were $492.2 million. Related expenses of the offering amounted to approximately $5.9 million. These costs were deferred and are being amortized over the term of the subordinated notes.
Variable rate unsecured subordinated notes in the amounts of €7 million and $27 million due March 2035 and March 2036, respectively, issued by Catlin Underwriting (formerly Wellington Underwriting plc) in May 2006. The notes were subordinated to the claims of all senior creditors, as defined in the agreement governing the notes. The notes paid interest at a floating rate based on the rate on three-month deposits in U.S. dollars plus a margin of 295 basis points and 317 basis points, respectively. Interest was payable quarterly in arrears.
On June 29, 2017, XLIT issued €500 million ($568.8 million) of fixed to floating rate subordinated notes due June 2047, with a fixed coupon of 3.25% for a period of ten years, then a floating rate of three-month EURIBOR plus 2.90% thereafter. The notes were issued at 99.054% of the face amount and net proceeds were $558.3 million. Related expenses of the offering amounted to approximately $10.5 million. These costs were deferred and are being amortized over the expected life of the subordinated notes.
XLIT and the Company were in compliance with all applicable covenants at December 31, 2017 and 2016.
The Company has several credit facilities provided on both syndicated and bilateral bases from commercial banks. As described in more detail below, the Company may utilize the full capacity of these credit facilities to issue LOC in support of non-admitted insurance and reinsurance operations in the U.S., and to meet capital requirements at Lloyd's. Alternatively, under certain of the credit facilities, the Company instead may elect to utilize a stated portion of such facilities' capacity for revolving loans to support other operating or financing needs, which would reduce the amount available for LOC. XL Group and several of its wholly-owned subsidiaries provide guarantees, on a joint and several basis, for obligations of the Company under certain of these facilities.
The following table presents the Company's ten and nine unsecured LOC facilities and revolving credit facilities at December 31, 2017 and December 31, 2016, respectively:
The availability of letters of credit under the Secured Syndicated Facility is subject to a borrowing base requirement, determined on the basis of specified percentages of the face value of eligible categories of assets varying by type of collateral. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedants. This could take the form of insurance trusts supported by the investment portfolio or funds withheld (amounts retained by ceding companies to collateralize loss or premium reserves) using the Company's cash resources or combinations thereof. The face amount of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
On September 15, 2017, the Company entered into a new credit agreement with Commerzbank AG, as administrative agent and issuing lender ("2017 Commerzbank Facility"). The capacity available under this standby letter of credit is $100 million. The commitments under the 2017 Commerzbank Facility expire on, and such credit facility is available until, the earlier of (i) September 15, 2022 and (ii) the date of termination in whole of the commitment upon an optional termination or reduction of the commitment by the account party or upon the occurrence of certain events of default.
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.
At December 31, 2017 and 2016, the Company owned minority stakes in three and four independent investment management companies ("Investment Manager Affiliates"), respectively, that are actively managing client capital and seeking growth opportunities. 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, pays management fees and, in some instances, performance fees to the Company's Investment Manager Affiliates. In addition, at December 31, 2017 and 2016, the Company owned a minority stake in an independent firm that provides technology and other services to alternative asset managers and allocators. The Company's interest in this enterprise is reported as an Investment Manager Affiliate, and the Company pays fees to this Investment Manager Affiliate in exchange for it providing its services to the Company. Investment Manager Affiliate results are reported in the Consolidated Statements of Income as "Income (loss) from operating affiliates." See Note 5, "Investments in Affiliates," included herein, for further information.
After the establishment of New Ocean in 2013, the Company, along with other investors, formed a new Bermuda-based company, New Ocean Focus Cat Fund Ltd. ("New Ocean FCFL"), which is considered a VIE under GAAP. During the second quarter of 2014, the company formed another Bermuda-based investment company, New Ocean Market Value Cat Funds, Ltd. ("New Ocean MVCFL"), which is also considered a VIE under GAAP. New Ocean MVCFL primarily invests in insurance-linked securities, with a current focus on catastrophe bonds.
A contributory defined benefit pension plan exists in the U.K., but has been closed to new entrants since 1996. Benefits are based on length of service and compensation as defined in the trust deed and rules. The pension liability recorded was $2.3 million and $4.1 million at December 31, 2017 and 2016, respectively, representing the entire unfunded projected obligation.
In connection with the Catlin Acquisition in 2015 the Company assumed additional assets and liabilities associated with a further U.K. defined benefit plan within Catlin. This plan has been closed to new members since 1993. The current membership consists only of pensioners and deferred members. Benefits are based on length of service and compensation.
The Company also acquired certain defined benefit pension liabilities with the acquisition of XL GAPS in 2007. The related balances are not included in the tables below as the liabilities are insured under an annuity type contract.
The funded status by geographical region of all the Company's retirement plans at December 31, 2017 and 2016 is as follows:
The status of all the Company's retirement plans at December 31, 2017, 2016 and 2015 is as follows:
The third fund seeks to outperform longer-duration benchmarks without excess volatility through investing primarily in long-duration, investment-grade corporate and sovereign bonds.
As the remaining other European plans are unfunded, they held no plan assets at December 31, 2017 and 2016.
Under the U.S. defined benefit plans, the Company's policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. The contribution level is determined by utilizing the projected unit credit cost method and different actuarial assumptions than those used for pension expense purposes. The Company's funding policy provides that contributions to the plan shall be at least equal to the minimum funding requirements of the Employee Retirement Income Security Act of 1974 ("ERISA"), as amended by the Pension Protection Act of 2006. During the fiscal year beginning January 1, 2018, the U.S. defined benefit plans expect to make contributions of $1.4 million.
With respect to the U.K. plan assumed as part of the Catlin Acquisition, the most recent funding valuation was prepared as at October 1, 2016. No contributions were required following that valuation. During 2018, it is expected that no contributions will be paid to the plan.
The creditworthiness of any counterparty is evaluated by the Company, taking into account credit ratings assigned by rating agencies. The credit approval process involves an assessment of factors including, among others, the counterparty and country and industry credit exposure limits. Collateral may be required, at the discretion of the Company, on certain transactions based on the creditworthiness of the counterparty.
The Company's reinsurance assets result from reinsurance arrangements in the course of its operations. A credit exposure exists with respect to reinsurance assets as they may be uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
The Company did not have an aggregate direct investment in any single corporate issuer in excess of 5% of the Company's shareholders' equity at December 31, 2017 and 2016. Corporate issuers represent only direct exposure to fixed maturities and short-term investments of the parent issuer and its subsidiaries. These exposures exclude asset and mortgage backed securities that were issued, sponsored or serviced by the parent and government-guaranteed issues, but do include covered bonds.
XL Group is a Bermuda exempted company and, except as described below, neither it nor its non-U.S. subsidiaries have paid U.S. corporate income taxes on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the United States. However, because definitive identification of activities that constitute being engaged in a trade or business in the United States is not provided by the Internal Revenue Code ("IRS Code"), regulations or court decisions, there can be no assurance that the Internal Revenue Service will not contend that the Company or its non-U.S. subsidiaries are engaged in a trade or business or otherwise subject to taxation in the United States. If the Company or its non-U.S. subsidiaries were
considered to be engaged in a trade or business in the United States (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the United States and Bermuda and other countries in which the Company operates, such businesses would be considered to be attributable to a "permanent establishment" in the United States), the Company or such subsidiaries could be subject to U.S. tax at regular tax rates on their respective taxable income that is effectively connected with their U.S. trade or business plus an additional "branch profits" tax (at a rate as high as 30%) on such income remaining after the regular tax, in which case there could be a significant adverse effect on the Company's results of operations and financial position.
At December 31, 2017 and 2016, $2.5 billion and $2.3 billion of letters of credit were outstanding, of which 54.2% and 48.6%, respectively, were collateralized by the Company's investment portfolios, primarily supporting U.S. non-admitted business and the Company's Lloyd's syndicates' capital requirements.
Legal actions are subject to inherent uncertainties, and future events could change management's assessment of the probability or estimated amount of potential losses from pending or threatened legal actions. Based on available information, it is the opinion of management that the ultimate resolution of pending or threatened legal actions other than claims proceedings, both individually and in the aggregate, will not result in losses having a material adverse effect on the Company's financial position or liquidity at December 31, 2017.
In February 2017, the Company negotiated the termination of its final outstanding financial guarantee contracts. These contracts provided credit support for a variety of collateral types, including some issued by European financial institutions. The Company will not recognize any financial costs or any security valuation losses as a result of these terminations.
As a result of the Redomestication discussed in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," prior to July 25, 2016, share information relates to the ordinary shares of XL-Ireland and its consolidated subsidiaries. On and subsequent to July 25, 2016, share information relates to the common shares of XL Group and its consolidated subsidiaries.
In connection with the Catlin Acquisition described in Note 2(f), "Acquisitions and Disposals - Catlin Acquisition," the Company issued 49.9 million ordinary shares of XL-Ireland to Catlin shareholders, which had an aggregate value as of the Acquisition Date of $1.85 billion.
Includes share buybacks associated with authorized share buyback 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 equity compensation programs.
Other share buybacks, primarily for purposes of settling employee withholding taxes incurred in connection with the vesting of share-based compensation awards, amounted to $0.7 million for the year ended December 31, 2017. In total, the Company purchased and canceled 13.8 million XL Group shares, for $571.6 million during the year ended December 31, 2017.
All share buybacks were carried out in accordance with applicable law, including prior to July 25, 2016 by way of redemption in accordance with Irish law. All shares so redeemed were canceled upon redemption.
The Series D Preference Ordinary Shares and Series E Preference Ordinary Shares discussed in this section were issued by XLIT and do not represent share capital of XL Group. XL Group has no preferred shares outstanding and has never issued any preferred shares.
On July 7, 2017, the Company repurchased through a tender offer and canceled 329,722 of the outstanding Series E Preference Ordinary Shares with a net carrying value of $324.4 million for $310.6 million, inclusive of transaction costs and other consideration. As a result of these repurchases, the Company recorded a gain of $13.7 million through "Non-controlling interests" in the Consolidated Statements of Income.
The Company currently maintains the following performance incentive programs: the XL Group Ltd Amended and Restated 1991 Performance Incentive Program (the "1991 Program"), the XL Group Ltd Directors Stock & Option Plan (the "Directors Plan", and together with the 1991 Program, the "Programs"). The Programs provide that the securities to be issued pursuant to each Program are of XL Group.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company's closing stock price on the last trading day of the 2017 fiscal year and the exercise price, multiplied by the number of in-the-money-options) that would have been received by the option holders had all option holders exercised their options on December 31, 2017. Total unrecognized stock-based compensation expense related to non-vested stock options was approximately $9.8 million at December 31, 2017, which related to approximately 2.9 million options and is expected to be recognized over a weighted-average period of 1.1 years.
Restricted stock awards issued under the Programs vest as set forth in the applicable award agreements. Each restricted stock award represents the Company's obligation to deliver to the holder one XL Group share. The employees and directors who are granted a restricted stock award have all the rights of a shareholder, including the right to vote and receive dividends, but the shares are subject to certain restrictions prior to vesting relating to, among other things, forfeiture in the event of termination of employment and transferability.
A summary of the restricted stock awards issued under the Programs for the indicated years ended December 31, 2017, 2016 and 2015 is as follows:
Total unrecognized stock based compensation expense related to non-vested restricted stock awards was nil at December 31, 2017, which is related to approximately 0.1 million restricted stock awards.
Each restricted stock unit represents the Company's obligation to deliver to the holder one XL Group share upon satisfaction of the three-year vesting term. Restricted stock units are granted at the closing market price on the day of grant and entitle the holder to receive dividends declared and paid in the form of additional XL Group shares contingent upon vesting.
Total unrecognized stock-based compensation expense related to non-vested restricted stock units was $48.5 million at December 31, 2017, which is related to approximately 2.1 million restricted stock units and is expected to be recognized over 1.5 years.
Non-vested restricted stock units at December 31, 2017 and for the year then ended were as follows:
During the year ended December 31, 2017, the Company granted approximately 0.6 million liability-classed stock units to certain employees with an aggregate grant date fair value of approximately $22.7 million. Each liability-classed restricted stock unit represents the Company's obligation to deliver to the holder a cash payment equivalent to the value of one common share. The grants may vest either in three equal installments upon the first, second and third anniversaries of the date of grant; or in two equal installments upon the first and second anniversaries of the date of grant. Liability-classed restricted stock units are granted at the closing market price on the day of grant and entitle the holder to receive dividends declared and are paid in cash contingent upon vesting.
Total unrecognized stock-based compensation expense related to non-vested restricted cash units was approximately $42.9 million at December 31, 2017, which is related to approximately 2.1 million restricted cash units and is expected to be recognized over 1.3 years. Non-vested restricted cash units as of December 31, 2017 were as follows:
XL Group's Bye-laws restrict the voting power of any person to less than approximately 10% of the total voting power.
The following table sets forth the computation of basic and diluted earnings per common share for the years ended December 31, 2017, 2016 and 2015:
Due to the net loss in the period, basic and diluted earnings per common share are calculated using the basic weighted average common shares outstanding for the year ended December 31, 2017. The shares excluded from the calculation amounted to approximately 3.7 million.
For the years ended December 31, 2017, 2016 and 2015, common shares available for issuance under share-based compensation plans noted in the table below were not included in the calculation of diluted earnings per common share because the assumed exercise or issuance of such shares would be anti-dilutive.
On January 8, 2018, the Board of Directors of XLIT resolved on January 8, 2018 to pay a dividend of $9.7537 per share on XLIT's Series E Preference Ordinary Shares. The dividend was paid on January 16, 2018 to all shareholders of record at January 8, 2018.
On January 8, 2018, the Board of Directors of Catlin-Bermuda resolved to pay a dividend in the aggregate amount of $6.1 million on CICL Prefs. The dividend was paid on January 19, 2018 to all shareholders of record at December 31, 2017.
The changes in AOCI, net of tax, by component for the years ended December 31, 2017, 2016 and 2015 are as follows:
For certain annuity contracts that are subject to the GreyCastle Life Retro Arrangements, policy benefit reserves were historically increased for the impact of changes in unrealized gains on investments supporting such contracts as if the gains had been realized, with a corresponding entry to other comprehensive income ("Shadow Adjustments"). Upon completion of the GreyCastle Life Retro Arrangements, no further Shadow Adjustments were recorded. As of December 31, 2016, the cumulative impact of the Shadow Adjustments was $212.1 million. During the year ended December 31, 2017, net movement of $(27.2) million were recorded, resulting in a total cumulative net impact of Shadow Adjustments on future policy benefit reserves of $184.9 million at December 31, 2017.
During the the year ended December 31, 2017, the Company recorded an out-of-period reduction of $17.4 million to "Foreign currency translation adjustments, net of tax," within the Consolidated Statements of Comprehensive Income. This adjustment arose from a previously unrecognized tax liability on foreign exchange movements that should have been reflected in the comprehensive income of a prior period. The Company has evaluated the quantitative and qualitative aspects of this correction and concluded that the impact of recognizing it during this year is not material to the Consolidated Financial Statements, nor is it material to any prior period Consolidated Financial Statements.
The reclassifications out of AOCI along with the associated Consolidated Statements of Income line items affected by component, and the total related tax (expense) benefit for indicated years ended December 31, 2017, 2016 and 2015 are as follows:
The Company, and its Bermuda subsidiaries, are not subject to any income or capital gains taxes under current Bermuda law. In the event that there is a change such that these taxes are imposed, the Bermuda subsidiaries would be exempted from any such tax until March 2035 pursuant to the Bermuda Exempted Undertakings Tax Protection Act 1966, and the Exempted Undertakings Tax Protection Amendment Act 2011.
On December 22, 2017, the U.S Tax Cuts and Jobs Act was enacted. The new law, which takes effect for taxable years beginning on or after January 1, 2018, includes numerous changes in tax law, including: (1) a reduction in the federal corporate income tax rate from 35% to 21%; (2) repeal of the corporate Alternative Minimum Tax, with existing credit carryforwards refundable no later than 2021; (3) limitations on the deductibility of certain elements of executive compensation; and (4) a number of base erosion provisions designed to reduce the ability of multinational companies to reduce the U.S. tax base through payments to offshore affiliates.
On December 22, 2017, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 118 (“SAB 118”), which provides guidance on accounting for the income tax effects of the U.S. Tax Cuts and Jobs Act. SAB 118 provides scenarios where the measurement of the income tax effects is complete, incomplete, or incomplete but for which a reasonable provisional amount can be estimated, and provides a twelve month measurement period from the enactment date to complete the accounting.
Based on its initial analysis of the provisions of the new tax law, and associated guidance issued to date, the Company recorded a net income tax expense of $100.5 million in the period ended December 31, 2017, primarily to reduce the value of its net deferred tax assets to reflect the reduction in the U.S. federal corporate income tax rate. In accordance with SAB 118, the accounting for the income tax effects of the rate change on the net deferred tax asset is complete.
The Company has recorded provisional amounts that are incomplete, but have been reasonably estimated, related to the re-computation of its insurance reserves and the transition adjustment from the existing laws. The Company may reflect adjustments to its provisional amounts upon issuance of additional guidance with respect to the operation of the new tax law provisions, or by obtaining, preparing, or analyzing additional information about facts and circumstances that existed as of the enactment date that, if known, would have affected the income tax effects initially reported as provisional amounts. The Company does not expect these adjustments to be material to its financial position.
With the exception of the U.S., deferred income taxes have not been accrued with respect to certain undistributed earnings of subsidiaries located outside of Bermuda. If the earnings were to be distributed, as dividends or otherwise, such amounts may be subject to withholding taxation in the jurisdiction of the paying entity. The Company does not assert that all earnings arising in the U.S. will be permanently reinvested in the U.S., and accordingly, the Company provides for withholding taxes arising in respect of current period U.S. earnings. No withholding taxes are accrued with respect to the earnings of the Company's subsidiaries arising outside the U.S. However, if there is a change in tax law, interpretation of existing law, or change in way in which the Company conducts its business, then the company would accrue the required withholding tax.
The table below details the tax years that are open to assessment and under examination by local tax authorities, by major tax jurisdictions. While the Company cannot estimate with certainty the outcome of these examinations, the Company does not believe that adjustments from open tax years will result in a significant change to the Company's financial results.
The Company's income (loss) before income tax and non-controlling interests, for the years ended December 31, 2017, 2016 and 2015, was distributed between U.S. and non-U.S. jurisdictions as follows:
The deferred tax asset and deferred tax liability balances presented above represent the gross deferred tax asset and liability balances across each tax jurisdiction. As disclosed on the Consolidated Balance Sheets, the deferred tax asset balances of $332.0 million and $310.5 million at December 31, 2017 and 2016, respectively, and deferred tax liability balances of $57.6 million and $77.3 million at December 31, 2017 and 2016, respectively, include netting of certain deferred tax assets and liabilities within a tax jurisdiction to the extent such netting is consistent with ASC 740 "Income Taxes".
At December 31, 2017 and 2016, the valuation allowance of $338.6 million and $367.4 million, respectively, related primarily to net operating loss and realized capital loss carryforwards in the following major tax jurisdictions:
Management believes it is more likely than not that the tax benefit associated with the Company's deferred tax assets, not offset by a valuation allowance, will be realized.
The following table summarizes the net operating loss carryforwards the Company had at December 31, 2017:
At December 31, 2017, the Company had total tax credits of $53.3 million, comprised of: (1) $31.7 million of U.S. Alternative Minimum Tax Credits, which are refundable no later than 2021; (2) $3.0 million of U.S. foreign tax credits that expire through 2021; (3) $3.1 million of U.S. Research and Development tax credits which expire through 2034; and (4) $15.5 million of U.K. foreign tax credits that do not expire.
For the years ended December 31, 2017, 2016 and 2015, the Company had unrecognized tax benefits of $65.0 million, $97.8 million and $80.6 million, respectively. If recognized, the full amount of these unrecognized tax benefits would generally decrease the current year annual effective tax rate. The Company does not currently anticipate any significant change in unrecognized tax benefits during 2018.
The following table presents a reconciliation of the Company's unrecognized tax benefits:
The Company's ability to pay dividends or return capital from shareholders' equity is limited by applicable laws and regulations of the various jurisdictions in which the Company's principal operating subsidiaries operate, certain additional required regulatory approvals and financial covenants contained in the Company's credit facilities and other debt documents. The payment of dividends to XL Group and XLIT, the Company's holding companies, and by the Company's principal operating subsidiaries is regulated under the laws of various jurisdictions including Bermuda, the U.K., Ireland and Switzerland and certain insurance statutes of various U.S. states in which the principal operating subsidiaries are domiciled and the other jurisdictions where the Company has regulated subsidiaries. The Bermuda Monetary Authority (the "BMA") is the group supervisor of XL Group. The BMA's group rules require an assessment of group capital and solvency and XL Group is required to meet the BMA's group capital requirements.
Required statutory capital and surplus at December 31, 2017 represents 100% Bermuda Solvency Capital Requirement ("BSCR") level for the top Bermuda operating subsidiary, XL Bermuda Ltd, calculated on a consolidated basis (and therefore includes a BSCR requirement for all regions).
Statutory net income (loss) for the principal operating subsidiaries of the Company for the years ended December 31, 2017, 2016 and 2015 is summarized below:
Certain restrictions on the payment of dividends from retained earnings by the Company's principal operating subsidiaries are further detailed below.
Management has evaluated the group and principal operating subsidiaries' ability to maintain adequate levels of statutory capital, liquidity and rating agency capital and believes they will be able to do so. In performing this analysis, management has considered the most recent statutory capital position of each of the principal operating subsidiaries as well as the group overall, through its holding companies as a result of BMA group regulation. In addition, management has evaluated the ability of the holding companies to allocate capital and liquidity around the group as and when needed.
In early July 2008, the Insurance Amendment Act of 2008 was passed, which introduced a number of changes to the Bermuda Insurance Act 1978, such as allowing the BMA to prescribe standards for an enhanced capital requirement and a capital and solvency return with which insurers and reinsurers must comply. The BSCR employs a standard mathematical model that can relate more accurately the risks undertaken by (re)insurers to the capital that is dedicated to their business. Insurers and reinsurers may adopt the BSCR model or, where an insurer or reinsurer believes that its own internal model better reflects the inherent risk of its business, an in-house model approved by the BMA. Class 4 (re)insurers, such as the Company, were required to implement the new capital requirements under the BSCR model beginning with fiscal years ending on or after December 31, 2009. The Company's capital requirements for its Bermuda principal operating subsidiaries, XL Bermuda Ltd and Catlin-Bermuda, under the BSCR are highlighted in the aggregate in the table above. In addition to the BSCR based requirements, the BMA also prescribes minimum liquidity standards that must be met.
At December 31, 2017, XL Group and XLIT held cash and investments, net of liabilities associated with cash sweeping arrangements, of $4.0 million and $0.7 billion respectively, compared to $1.0 million and $0.7 billion, respectively, at December 31, 2016.
The ability to declare and pay dividends may also be restricted by financial covenants in the Company's credit facilities and other debt documents. The Company was in compliance with all covenants at December 31, 2017, and the Company remains in compliance as of the date of this Form 10-K.