In June 2012, we acquired new offices at 8 St. Stephen’s Green, Dublin, Ireland as our new global headquarters. The acquisition purchase price was $9.6 million. Completion of the new office and consolidation of our existing Dublin locations are expected in mid-2013.
We generally record the income related to alternative fund affiliates on a one-month lag and the private investment fund affiliates on a three-month lag in order for us to meet the filing deadlines for its periodic reports. We generally record the income related to operating affiliates on a three-month lag.
Effective April 1, 2009, we adopted final authoritative guidance that addressed the treatment of credit losses on investments. This guidance was not applied retroactively.
Certain aspects of our business have loss experience characterized as low frequency and high severity. This may result in volatility in both our results of operations and financial condition.
Net Realized Gains and Losses on Investments and Other-Than-Temporary Declines in the Value Of Investments
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. Any prospectus, prospectus supplement, Annual Report to ordinary 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 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,” “intend,” “plan,” “believe,” “project,” “anticipate,” “will,” “may” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
changes in the projected amount of ceded reinsurance recoverables and the ratings and creditworthiness of reinsurers;
changes in general economic conditions, including the effects of inflation on our business, including on pricing and reserving, and 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 or access to such markets;
the potential for changes to methodologies, estimations and assumptions that underlie the valuation of our financial instruments that could result in changes to investment valuations;
the ability of our subsidiaries to pay dividends to XL-Ireland and XL-Cayman;
the effects of business disruption or economic contraction due to war, terrorism or other hostilities;
our ability to realize the expected benefits from the Redomestication; and
We continue to focus on those lines of business that we believe provide the best return on capital, including the writing of selective new business and remaining committed to the underwriting actions necessary to improve our margins. For 2013, initial indications are consistent with current market conditions described above.
In property catastrophe lines we saw loss impacted programs from Storm Sandy experience 10 to 15% rate increases while renewal rates for non-loss impacted U.S. programs were flat. In Europe, with the exception of Italy where we saw double digit increases as a result of the earthquake, prices decreased in the 3 to 5% range. For specialty lines, there were significant price increases in the marine lines due to Storm Sandy, which was the latest in a series of significant losses into that market, while rates in the aviation lines were flat to down 5% due to continued good experience. The casualty markets in both the U.S. and International still remain highly competitive. We saw certain ceding companies increasing their retention levels, a pattern we have seen repeatedly in recent years, while reinsurers that tried to increase their line size at renewal, did so with limited success.
The Reinsurance segment continues to develop new business opportunities in several areas and in 2013, we expect to continue to build upon the strategic growth achieved in recent years and will utilize our broad market relationships and experience to seek opportunities to achieve this.
We seek to generate book value growth and investment income from investment activities through the total returns on our investment portfolio. During the year ended December 31, 2012, credit spreads tightened and interest rates declined in the majority of the currencies in which we hold assets. Net investment income yields were negatively impacted by lower interest rates and spreads, which in turn reduced prevailing yields on reinvestment income. Net realized gains resulted from sales transactions primarily from a repositioning of the Agency RMBS portfolio and sales of equity and non-U.S. Sovereign Government securities. The impact of tightening credit spreads and decreasing interest rates during 2012 was the primary reason for the improvement in the net unrealized position on fixed maturities and short-term investments over the course of the year. For further information, see “Investment Activities” below.
One way that we evaluate the performance of our insurance and reinsurance operations is by underwriting profit or loss. We do not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned less net losses incurred and expenses related to underwriting activities. Our underwriting profit (loss) in the year ended December 31, 2012 was consistent with the combined ratio discussed below.
In the P&C industry, the combined ratio is a widely used measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net
Our combined ratio of 96.3% for the year ended December 31, 2012 was lower than the 107.5% combined ratio in 2011, primarily due to a decrease in the loss and loss expense ratio while the underwriting expense ratio was flat. The loss and loss expense ratio, which is the ratio of losses and loss expenses incurred to net premiums earned, has decreased as a result of lower levels of catastrophe losses and other large loss events as compared to 2011. The underwriting expense ratio, which was flat year on year, is the ratio of the sum of acquisition costs and operating expenses to the net premiums earned.
Operating net income is a non-GAAP financial measure defined as net income (loss) attributable to ordinary shareholders excluding: (1) our net realized gains and losses on investments, net of tax, (2) our net realized and unrealized gains and losses on derivatives, net of tax, (3) our share of items (1) and (2) for our insurance company affiliates for the periods presented, (4) goodwill impairment charges, net of tax, (5) the gains recognized on our repurchase of XL-Cayman’s preference ordinary shares and (6) foreign exchange gains or losses, net of tax. We evaluate the performance of and manage our business to produce an underwriting profit. In addition to presenting net income (loss), we believe that showing operating net income (loss) enables investors and other users of our financial information to analyze our performance in a manner similar to how we analyze performance. In this regard, we believe that providing only a GAAP presentation of net income (loss) makes it more difficult for users of our financial information to evaluate our underlying business. We also believe that the equity analysts and certain rating agencies that follow us (and the insurance industry as a whole) exclude these items from their analyses for the same reasons and they request that we provide this non-GAAP financial information on a regular basis. A reconciliation of our net income (loss) attributable to ordinary shareholders to operating net income (loss) is provided at the end of “Key Financial Measures” below.
Book value per ordinary share increased by $5.37 in 2012 as compared to a decrease of $0.52 during 2011. The increase in 2012 was primarily due the net income attributable to ordinary shareholders, an increase in net unrealized gains on investments and the benefit of share buyback activity.
Our net income and other financial measures as shown above for the year ended December 31, 2012 have been affected by, among other things, the following significant items:
Notable natural catastrophes during 2012 included Storm Sandy (“Sandy”), U.S. tornadoes and the large earthquake in Italy.
Notable natural catastrophes during 2011 included the March 11, 2011 earthquake and tsunami in Japan, the earthquake that struck Christchurch, New Zealand on February 22, 2011, the 2011 flooding events in Australia, the severe weather occurrences, including tornado activity, in the United States during April and May 2011, the Atlantic Hurricanes (Hurricane Irene and Tropical Storm Lee) and the Thailand floods.
Notable natural catastrophes during 2010 included the Chilean Earthquake, European Windstorm Xynthia, U.S. tornadoes and hailstorm activity, the New Zealand Earthquake and floods in Central Europe, China, Poland and Queensland, Australia.
For the Insurance segment, for the year ended December 31, 2012, Other natural catastrophes include Italy snow storm, U.S.Tornadoes, Italy earthquake, Hurricane Isaac, Costa Rica Earthquake and New South Wales floods.
For the Reinsurance segment for the year ended December 31, 2012, Other natural catastrophes include U.S.Tornadoes, Italy earthquake, Hurricane Isaac, and Calgary hailstorm.
Reinsurance segment. In addition, the results from operations during the year ended December 31, 2012 were affected by crop losses attributable to the severe drought conditions in the United States in 2012. Our preliminary loss estimate for these drought and crop losses net of reinsurance recoveries and reinstatement premiums was $30.8 million, all attributable to the Reinsurance segment.
Soft market conditions were experienced across most lines of business throughout 2010, 2011 and 2012. This resulted in an overall decrease in gross and net premiums written in 2010 but these amounts increased in 2011 and 2012 due to new strategic initiatives and certain rate improvements. For further information in relation to the underwriting environment, including details relating to rates and retention, see “Executive Overview - Underwriting Environment and Outlook for 2013,” above.
We remain focused on, among other things, managing capital, enhancing enterprise risk management capabilities and monitoring regulatory change. Details of these initiatives are outlined below.
Probable maximum losses, which include secondary uncertainty that incorporates variability around the expected probable maximum loss for each event, do not represent our maximum potential exposures and are pre-tax.
Management continues to actively monitor and assess the various regulatory initiatives and legislation that impacts us or in the future could impact us. For example, management has been focused on Solvency II, which was adopted by the European Parliament in April 2009. This is an E.U. directive covering the capital adequacy and risk management of, and regulatory reporting for, European-based (re)insurers, as well as a new supervisory regime for the insurance industry. Several steps must be taken by the European Commission, the European Parliament, the Council of Ministers and EIOPA to implement Solvency II. The final date of implementation and key elements of the framework remain under discussion, but it is widely accepted that the envisaged implementation date of January 1, 2014 will not be met. However, management currently continues to prepare for potential Solvency II implementation at a future date. See Item 1, “Business - Regulation.”
Case reserves for our property and casualty operations are established by management based on amounts reported from insureds or ceding companies and consultation with legal counsel, and represent the estimated ultimate cost of events or conditions that have been reported to or specifically identified by us. The method of establishing case reserves for reported claims differs among our operations.
IBNR reserves represent management’s best estimate, at a given point in time, of the amount in excess of case reserves that is needed for the future settlement and loss adjustment costs associated with claims incurred. It is possible that the ultimate liability may differ materially from these estimates. Because the ultimate amount of unpaid losses and LAE is uncertain, we believe that quantitative techniques to estimate these amounts are enhanced by professional and managerial judgment. Management reviews the IBNR estimates produced by our actuaries who determine the best estimate of the liabilities to record in our financial statements. We consider this single point estimate to be the mean expected outcome.
IBNR reserves are estimated by our actuaries using several standard actuarial methodologies including the loss ratio method, the loss development or chain ladder method, the Bornhuetter-Ferguson (“BF”)
The pattern of loss emergence is determined using actuarial analysis and judgment and is based on the historical patterns of the recording of paid and reported losses by us, as well as industry information. Information that may cause historical patterns to differ from future patterns is considered and reflected in expected patterns as appropriate. For property, marine and aviation insurance, losses are generally reported within 2 to 3 years from the beginning of the accident year. For casualty insurance, loss emergence patterns can vary from 3 years to over 20 years depending on the type of business. For other insurance, loss emergence patterns fall between the property and casualty insurance. For reinsurance business, loss reporting lags the corresponding insurance classes often by at least one quarter due to the need for loss information to flow from the ceding companies to us generally via reinsurance intermediaries. Such lags in loss reporting are reflected in the actuary’s selections of loss reporting patterns used in establishing our reserves.
Such estimates are not precise because, among other things, they are based on predictions of future developments and estimates of future trends in claim severity, claim frequency and other issues. In the process of estimating IBNR reserves, provisions for economic inflation and changes in the social and legal
Discontinued asbestos and long-tail environmental business was contained within certain policies previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to its acquisition by us; from business of Winterthur purchased by us from AXA Insurance in 2001; and from a loss portfolio transfer in 2006. At December 31, 2012, total gross unpaid losses and loss expenses in respect of this business represented less than 1% of unpaid losses and loss expenses. See Note 10(f), “Losses and Loss Expenses - Discontinued Asbestos and Run-Off Environmental Related Claims,” to the Consolidated Financial Statements included herein for further information.
The amount of our net unpaid losses and loss expenses relating to our operating segments at December 31, 2012 and 2011 was as follows.
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 ratio of IBNR to total reserves was consistent from year-end 2011 to year-end 2012.
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, 2012:
forth in the above table are such that there is a 10% modeled probability that the reserve will develop higher than the high point and a 10% modeled probability that the reserve will develop lower than the low point.
The future policy benefit reserves for annuity portfolio reinsurance contracts amounted to $4.0 billion at both December 31, 2012 and 2011. The requirement to unlock assumptions used to value these reserves arising from changes to assumptions on investment yield and mortality is discussed below along with sensitivities for changing mortality and investment yield assumptions.
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the issue of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency exists. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e., mortality and interest). Provisions for adverse deviation are designed to cover reasonable deviations from the best estimate outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such review would produce reserves in excess of those currently held then lock-in assumptions will be revised and a loss recognized. Such a loss could be significant relative to the net income of the Life operations segment for the year, but would not be expected to be significant relative to shareholders’ equity. The future policy benefit reserves provisions for adverse deviation in excess of best estimate assumptions consistent with the underlying pricing that amounted to approximately $52 million and $36 million at December 31, 2012 and 2011, respectively. The reduction in 2012 has arisen due to the narrowing of credit spreads on the underlying assets over the year.
The future policy benefit reserves would only be increased if these provisions for adverse deviation no longer existed in the light of emerging claims experience. The present value of future claims would increase by approximately $17 million if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions. We hold the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile. A 0.1% decrease in the investment yield assumption would result in approximately a $32 million increase in the value of future claims related to annuity portfolio reinsurance.
During the years ended December 31, 2012, 2011 and 2010, there were no adjustments to the locked-in assumptions for these annuity reinsurance contracts.
We also provide reinsurance of disability income protection, for an in-force block of business. The future policy benefit reserves for these contracts amounted to approximately $101 million and $99 million at December 31, 2012 and 2011, respectively. 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 an 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 $2.3 million, while a 1% decrease in the termination rate would increase the value of future claims by
The liabilities relate to in-force blocks of business and to treaties that accepted new business up until the end of 2009, comprising underlying insurance policies that provide mainly lump sum benefits if the policyholder dies or becomes sick. For term assurance, the liabilities are therefore driven by the rates of mortality and for critical illness cover, the liabilities are driven predominantly by the rates at which policyholders become sick, where sickness is defined by the treaty conditions (i.e., the morbidity rates). A 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $2.7 million, and a 1% increase in the morbidity rate would increase the value of future claims by approximately $1.0 million.
If we intend to sell an impaired debt security, or it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, the impairment is other-than-temporary and is recognized in earnings in an amount equal to the entire difference between fair value and amortized cost.
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, our liability profile, 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 our 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. See “Investment Activities” herein for further information on other-than-temporary declines in the value of investments and unrealized loss on investments.
We, in conjunction with our third-party investment management service providers, make significant assumptions in our impairment analysis and these assumptions are subject to changes in both economic fundamentals and management’s estimates in future periods.
The weighted scenario of the five scenarios above is used for the determination of a potential impairment. If losses are forecast to be below the subordination level for the tranche held by us, the security is determined not to be impaired. The weighting between these scenarios varies over time depending on market conditions, but the weighting used for the year end 2012 evaluation consisted of 40% to the base cases noted above, 10% to the optimistic case, 10% to the pessimistic case, and 40% to the market implied case. For the non-CLO portion of the core CDO portfolio, we utilize specific default scenarios related to the particular underlying assets.
CMBS, which are dominated by AAA rated holdings which generally have high levels of credit subordination, are highly diversified and priced reasonably close to par. The gross unrealized losses on CMBS are spread evenly across the credit ratings. We review these holdings on an individual security basis to the extent they meet the screens noted above, but generally do not believe these securities have a high risk of credit loss given their high subordination levels.
We utilize the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We had net operating tax loss carry forward balances of $83.1 million and $263.6 million against which a valuation allowance of $73.8 million and $239.1 million at December 31, 2012 and 2011, respectively, was established. We had realized capital loss carry forward balances of approximately $196.5 million and $237.2 million against which a valuation allowance of approximately $196.5 million and $237.2 million at December 31, 2012 and 2011, respectively, was established. Included within these realized capital losses are $97.6 million and $117.9 million of losses arising from the intercompany sale of investments, against which a valuation allowance of $97.6 million and $117.9 million has been established. The deferral of benefits from tax losses is evaluated based upon management’s estimates of the future profitability of our taxable entities based on current forecasts, the character of income and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax affected.
For further information see “-Other Revenues and Expenses” and Item 8, Note 22, “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 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 actual premium by the ceding companies are recorded at the earliest point in time that the supporting information indicates an adjustment is appropriate.
At December 31, 2012 and 2011, the amount of premiums receivable related to our reinsurance operations amounted to $1.2 billion and $1.1 billion, respectively.
In the following “Income Statement Analysis” discussion, the following ratios are used to explain the underwriting profit (loss) from our Insurance and Reinsurance segments:
The acquisition expense ratio related to the P&C operations is calculated by dividing the acquisition costs incurred by the net premiums earned for the Insurance and Reinsurance segments.
The operating expense ratio related to the P&C operations is calculated by dividing the operating expenses incurred by the net premiums earned for the Insurance and Reinsurance segments.
As outlined in Item 1, “Business,” our Insurance operations provide commercial property, casualty and specialty insurance products on a global basis. Products generally provide tailored coverages for complex corporate risks and include the following lines of business: property, casualty, professional liability, environmental liability, aviation and satellite, marine and offshore energy, equine, fine art and specie, surplus lines, political risk and trade credit, product recall, surety and other insurance coverages, including those mentioned above, through our programs, middle market and construction businesses. We focus on those lines of business within our insurance operations that we believe provide the best return on capital over time. These lines of business are divided into the following business groups: North America Property and Casualty (“NAPC”), International Property and Casualty (“IPC”), Global Professional Lines (“Professional”) and Global Specialty Lines (“Specialty”).
IPC - increase of 11.8% largely driven by new business growth in property and middle market lines and the renewal of long term policies as annual policies in primary casualty, partially offset by a large multi-year program in primary casualty written in the fourth quarter of 2010 with gross written premiums of $126.5 million.
2012 vs. 2011: The increase of 9.8% resulted from the gross written premium increases outlined above together with a decrease in ceded written premiums. The decrease in ceded premiums primarily relates to:
Changes in the structure, protection layers and costs of certain property and IPC casualty reinsurance treaties;
Higher cost on certain excess of loss treaties and additional reinsurance placements on new business initatives; and
2012 vs. 2011: The increase of 7.1% primarily resulted from higher net written premiums earned in NAPC, Professional and Specialty and favorable amendments to certain prior year premium estimates, partially offset by lower production in IPC property as a result of underwriting actions for business that did not meet our return requirements and from ceded reinstatement premiums for marine and Sandy losses.
2011 vs. 2010: The increase of 3.8% primarily resulted from higher net written premiums earned through primary casualty, property, programs and middle markets and favorable foreign exchange impacts, offset by the ceded catastrophe, property and marine reinstatement premiums noted above and the earn-out of lower net premiums written in U.S. Professional and certain discontinued lines.
2012 vs. 2011: The 10.5 percentage point decrease in the loss ratio excluding prior year development was predominantly due to lower levels of catastrophe losses occurring in 2012. Losses net of reinsurance recoveries and reinstatement premiums related to natural catastrophe events were $132.1 million lower in 2012 as compared to 2011. For further details on catastrophe losses in 2012 and 2011, see “Results of Operations - Significant Items Affecting the Results of Operations - 1) The impact of significant large loss events.” Excluding prior year development, net catastrophe losses and related reinstatement premiums in both years, the loss ratio decreased by 6.4 points to 66.6%, due to large loss activity in the IPC and NAPC energy and property units in 2011, as well as business mix changes and underwriting improvements.
reinstatement premiums in both years, the loss ratio increased by 2.2 points from 2010 to 2011 due to higher large loss activity during 2011 in energy, property and marine businesses.
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, 2012, 2011 and 2010:
2012 vs. 2011: The increase of 0.8 points was due to an increase in the operating expense ratio of 0.2 points combined with an increase in the acquisition expense ratio of 0.6 points, as follows:
Operating expense ratio increase - mainly due to higher compensation expenses resulting from higher variable compensation costs and certain severance costs in 2012.
2011 vs. 2010: The increase of 1.2 points was due to an increase in the acquisition expense ratio of 0.8 points combined with an increase in the operating expense ratio of 0.4 points, as follows:
Net results from structured insurance products include certain structured indemnity contracts that are accounted for as deposit contracts.
2011 vs. 2010: The decrease was due to higher expenses related to our loss prevention consulting services partially offset by higher fee income in Specialty.
Bermuda - there was premium growth through favorable property catastrophe and other property renewals with price, share, line and capacity increases and new business.
International - premiums increased, attributable to casualty lines through significantly higher renewals and new business and increased property catastrophe shares and rates in Continental Europe.
Latin America - there was a decline in premiums due to the non-renewal of certain significant property and surety treaties as a result of the re-underwriting of the business within this region.
Latin America - there was a decline in premiums mainly due to the non-renewal of certain significant property treaties.
Foreign exchange rate movements also impacted our gross premiums written. When evaluated in local currency, our gross written premiums increased by 8.9%, compared to the 12.5% increase shown above.
2012 vs. 2011: The increase of 9.2% resulted from the International and Bermuda groups’ gross written premium increases described above coupled with a reduction in ceded written premiums in the North America business group. The decrease in ceded written premiums was mainly the result of the changes in the structure of a U.S. agricultural program, partially offset by higher prior period ceded reinstatement premiums in the International business group related to the 2011 Thailand flood loss.
2011 vs. 2010: The increase of 12.2% is a reflection of the overall growth in net premiums written in 2011 described above partially offset by an increase in ceded premiums written. The increase in ceded premiums written was mainly due to an increase in volume in 2011 associated with a U.S. agricultural program of which a significant portion was retroceded.
The loss and loss expense ratio includes net losses incurred for both the reported 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, 2012, 2011 and 2010:
2012 vs. 2011: The 12.4 percentage point decrease in the loss ratio excluding prior year development was predominantly due to lower levels of catastrophe losses occurring in 2012. Losses net of reinsurance recoveries and reinstatement premiums related to natural catastrophe events were $164.7 million lower in 2012 as compared to 2011. For further details on catastrophe losses in 2012 and 2011, see “Results of Operations - Significant Items Affecting the Results of Operations - 1) The impact of significant large loss events.” Excluding prior year development, net catastrophe losses and related reinstatement premiums in both years, the loss ratio decreased by 1.0 points to 54.1%, due mainly to business mix changes.
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, 2012, 2011 and 2010:
2012 vs. 2011: The decrease of 1.5 percentage points was due to a reduction in the operating expense ratio of 2.0 points partially offset by an increase in the acquisition expense ratio of 0.5 points, as follows:
Operating expense ratio decreased with reduced compensation costs due to decreased headcount and lower professional fees, while net earned premiums increased compared to 2011.
Acquisition expense ratio increase - the acquisition expense ratio was largely in line with 2011, with a slight increase from Latin America due to a favorable movement on sliding scale commissions in the prior year.
Operating expense ratio decrease - mainly as a result of lower compensation costs in 2011, partially offset by increased information technology expenses associated with certain strategic initiatives.
Net results from structured reinsurance products include certain structured indemnity contracts that are accounted for as deposit contracts.
of the larger structured indemnity contracts combined with lower net investment income reflecting lower investment yields and the run-off nature of this line of business.
2012 vs. 2011: The 10.5% decrease in net premium written and the 10.6% decrease in net earned premiums were consistent with the movements in total gross premiums written and the reduction in ceded written premiums already noted.
2012 vs. 2011: The 1.9% increase was largely due to a revision to profit commission estimates on the short-term life, accident and health business more than offsetting lower acquisition costs on the term and critical illness business.
2012 vs. 2011: Operating expenses were largely flat year on year; however, higher compensation expenses resulting from higher variable compensation costs in 2012, was offset by a reduction in information technology expenses.
2011 vs. 2010: The 1.6% increase was primarily due to positive foreign exchange impact, but was broadly in line with expected returns in underlying currencies.
We manage our fixed income portfolio in accordance with investment guidelines approved by the RFC. The following is a summary of the investment portfolio returns, which are calculated by dividing the sum of gross investment income or net income from investment affiliates, realized gains (losses) and unrealized
gains (losses) by the average market value of each portfolio, for the years ended December 31, 2012 and 2011 of the fixed income portfolio and non-fixed income portfolios:
The performance of investment portfolios is measured on a local currency basis and is not annualized. For aggregate performance calculation, respective local currency balances are translated to U.S. dollars at quarter end rates to calculate composite portfolio results.
For a summary of realized and unrealized gains and losses on all derivative instruments, see Item 1, Note 14, “Derivative Instruments,” to the Consolidated Financial Statements included herein.
2011 vs. 2010: The decrease of 7.4% was due to decreasing portfolio yields and cash outflows from the investment portfolio. Overall, portfolio yields have decreased due to declining interest rates across our major jurisdictions.
2012 vs. 2011: The increase was attributable to better performance from both alternative fund affiliates and private fund affiliates. Capital markets were moderately more supportive of our fund affiliates’
2011 vs. 2010: The decrease of 48.6% was attributable to weaker performance from our alternative and private investment portfolios given difficult market conditions in 2011. Performance in alternative and private funds in 2011 was challenged by volatile capital markets and the generally weaker returns to risk assets during 2011 as compared to the prior year.
Net realized gains on investments of $14.1 million included the following:
Net realized gains of $94.8 million resulted from sales transactions primarily from a repositioning of the Agency RMBS portfolio and sales of equity and non-U.S. Sovereign Government securities.
Net realized and unrealized gains on derivatives of $5.2 million in the year ended December 31, 2012 resulted from our investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments. For a further discussion, see Item 1, Note 14, “Derivative Instruments,” to the Consolidated Financial Statements included herein.
The following table sets forth the net income (loss) from operating affiliates for the years ended December 31, 2012, 2011 and 2010:
The financial operating affiliate loss in 2011 is wholly attributable to a write down in the value of one investment following a restructuring.
2012 vs. 2011: 2012 net income from investment manager affiliates was solid, but was significantly lower than 2011 results. The significant decrease in 2012 compared to 2011 results was due to the positive impact of the sale of our ownership stake in Finisterre in 2011 and especially strong performance by the investment manager affiliates (including Finisterre prior to the closing of the sale transaction). There were no sales of any stakes in 2012, and performance was solid but not especially strong during the period.
2011 vs. 2010: The substantial increase in 2011 as compared to 2010 reflected the positive impact of the sale of our ownership stake in Finisterre, strong results from certain investment manager affiliates in 2011 and, the achievement of results that surpassed certain performance fee hurdles by various funds under management in the second quarter of 2011, compared to solid broad-based results in 2010.
2011 vs. 2010: The increase of 73.5% was primarily as a result of certain strategic corporate initiatives taking place in 2011.
Interest expense includes costs related to the Company’s debt and collateral facilities and does not include deposit liability accretion which is included in Net investment results - structured products.
For further information about these debt financing transactions see Item 8, Note 13, “Notes Payable and Debt Financing Arrangements,” to the Consolidated Financial Statements included herein.
2012 vs. 2011: There were no goodwill impairments recorded during 2012. In 2011, a non-cash goodwill impairment charge of $429.0 million was recorded representing a write-off of all goodwill associated with the Insurance segment. For further information, see Item 8, Note 8 to the Consolidated Financial Statements, “Goodwill and Other Intangible Assets,” and see further discussion under “Critical Accounting Policies and Estimates.”
2011 vs. 2010: The tax charge of $59.7 million recognized in 2011 was lower than 2010 mainly as a result of a benefit of $11.9 million arising as a result of a change in an overseas tax rule adopted in the
quarter ended June 30, 2011. We incurred a tax charge in 2011 notwithstanding reporting net losses due to the distribution of operating profits across the organization and the impact of internal reinsurance. In addition, net profits were recorded in certain jurisdictions due to the distribution of prior year development. A tax benefit of $11.5 million was recognized in the fourth quarter of 2011 in respect of the non-cash goodwill impairment charge of $429.0 million.
We seek to generate book value growth and investment income from investment activities through the total returns on our investment portfolio. Our investment strategy, (see Item 1. “Business - Investments,”) strives to balance investment returns against market and credit risk. Our overall investment portfolio is structured to take into account a number of variables including liability profile, local regulatory requirements, business needs, collateral management and risk tolerance.
At December 31, 2012 and 2011, total investments, cash and cash equivalents, accrued investment income and net receivable/(payable) for investments sold/(purchased) were approximately $36.9 billion and $35.9 billion, respectively. The following table summarizes the composition of our invested assets at December 31, 2012 and 2011:
Carrying values represents the fair value for AFS fixed maturities and amortized cost for HTM securities.
U.S. Government and Government-Related/Supported and Non U.S. Sovereign Government, Provincial, Supranational and Government-Related/Supported include government-related securities with an amortized cost of $1,912.7 million and $1,878.3 million and fair value of $1,988.5 million and $1,915.6 million at December 31, 2012 and 2011, respectively, and U.S. Agencies with an amortized cost of $404.3 million and $494.0 million and fair value of $446.7 million and $541.2 million at December 31, 2012 and 2011, respectively.
Included within Corporate are certain floating rate medium term notes supported primarily by pools of European investment grade credit with varying degrees of leverage. The notes have a fair value of $194.3 million and $266.0 million and an amortized cost of $194.8 million and $297.7 million at December 31, 2012 and 2011, respectively. These securities have been allocated ratings based on the average credit rating of the underlying asset pools backing the notes. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.
At December 31, 2012, Covered Bonds within Fixed maturities - AFS with a carrying value of $647.1 million and Covered Bonds within Fixed maturities - HTM with a carrying value of $8.6 million have been included within Other asset-backed securities to align our classification to market indices. Covered Bonds were included in Corporate prior to January 1, 2012. At December 31, 2011, Covered Bonds within Fixed maturities - AFS with a carrying value of $353.9 million and Covered Bonds within Fixed maturities - HTM with a carrying value of $7.7 million were reclassified from Corporate to Other asset-backed securities to conform to the current period presentation.
Included within Equity securities are investments in fixed income funds of $101.9 million and $91.6 million at December 31, 2012 and 2011, respectively.
We review our corporate debt investments on a regular basis to consider their concentration, credit quality and compliance with established guidelines. At both December 31, 2012 and 2011, the average credit quality of our total fixed income portfolio (including fixed maturities, short-term investments, cash and cash equivalents and net receivable/(payable) for investment sold/(purchased)) was “Aa2/AA”. Included in the table below are the credit ratings of the fixed income portfolio excluding operating cash at December 31, 2012 and 2011:
The credit rating for each asset reflected above was principally determined based on the weighted average rating of the individual securities from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings (when available). U.S. Agency debt and related mortgage backed securities, whether with implicit or explicit government support, reflect the credit quality rating of the U.S. government for the purpose of these calculations.
gross unrealized losses of $55.3 million related to our Life operations investment portfolio, which had a fair value of $6.9 billion at December 31, 2012. Of these gross unrealized losses, $22.6 million related to $1.2 billion of exposures to corporate financial institutions, including $266.7 million related to Tier One and Upper Tier Two securities.
At December 31, 2012, this portfolio had an average interest rate duration of 8.8 years, primarily denominated in U.K. sterling and Euros. As a result of the long duration, significant gross losses have arisen as the fair values of these securities are more sensitive to prevailing government interest rates and credit spreads. This portfolio is generally matched to corresponding long duration liabilities. A hypothetical parallel increase in interest rates and credit spreads of 50 and 25 basis points, respectively, would increase the unrealized losses related to this portfolio at December 31, 2012 by approximately $307.9 million and $119.4 million, respectively, on both the AFS and HTM holdings in the Life operations investment portfolio.
Given the long-term nature of the Life operations investment portfolio, the level of credit spreads on financial institutions at December 31, 2012 relative to historical averages within the U.K. and Euro-zone and our liquidity needs at December 31, 2012, we believe that these assets will continue to be held until such time as they mature, or credit spreads on financial institutions revert to levels more consistent with historical averages.
Tier One and Upper Tier Two securities, representing committed term debt and hybrid instruments senior to the common and preferred equities of the financial institutions, are allocated based on the call date unless such security is not called on such date, in which case it is allocated the final or longest expected maturity. Medium term notes supported primarily by pools of European investment grade credit with varying degrees of leverage are allocated on contractual maturity.
The following is the maturity profile of the HTM fixed income securities that were in a gross unrealized loss position at December 31, 2012:
At December 31, 2012, approximately $1.2 billion of our $3.5 billion in corporate financial sector securities was held in the portfolio supporting our Life operations investment portfolio representing 20.4% of the net unrealized gains on this asset class. The assets associated with that business are more heavily weighted towards longer term securities from financial institutions, including a significant portion of our Tier One and Upper Tier Two securities, representing committed term debt and hybrid instruments senior to the common and preferred equity of the financial institutions. Financials held in the Life operations investment portfolio accounted for $22.8 million of our net unrealized loss at December 31, 2012. At December 31, 2012, approximately 42.3% of the overall sensitivity to interest rate risk and 35.5% of the overall sensitivity to credit risk was related to the Life operations investment portfolio, despite this accounting for only 20.3% of the fixed income portfolio.
The following table details the current exposures to structured securities excluding Agency RMBS within our fixed income portfolio as well as the current net unrealized (loss) gain position at December 31, 2012 and December 31, 2011:
We define Core CDOs as investments in non-subprime collateralized debt obligations, which primarily consisted of CLOs.
At December 31, 2012, our sub-prime, Alt-A and CDO exposures had adequate underlying asset characteristics and we believe at such date that the current amortized cost levels were at or below the discounted cash flow value of the holdings, based on an analysis of subordination levels relative to current expectations of prepayment rates, probability of default and loss severity in the event of default. Approximately $289.8 million of our Non-Agency RMBS were downgraded during the year ended December 31, 2012. However, 45.4% of our holdings in Non-Agency RMBS remained rated investment grade at December 31, 2012.
Our primary exposure to this European sovereign debt crisis is from direct investment in fixed maturity securities issued by GIIPS national and local governments, as well as from fixed maturity securities issued by certain financial and non-financial corporate entities operating within GIIPS. During the year we actively reduced our exposures to these securities. We continue to monitor our financial exposure to this crisis, and continually assess the impact of a potential default by any of GIIPS on their respective debt issuances, including the associated impact on non-sovereign entities in these five nations in the event of such a default. In reaction to mounting pressure from financial markets, the European Union and its members implemented several key initiatives in 2012 that helped alleviate concern over Europe’s long term debt sustainability. These included 1) ongoing measures to reduce deficits and lower debt to sustainable levels, 2) pan-European emergency funding vehicles such as the European Financial Stability Fund (“EFSF”) and later the European Stability Mechanism (“ESM”) to support new bond issuance, 3) the promise of Outright Monetary Transactions from the ECB to support near-term peripheral yields, and 4) implementation of Long Term Repo Operations to provide financial institution liquidity. These events helped calm credit markets and led to a string of successful bond auctions and lower sovereign yields for the GIIPS nations, although these programs have not been finalized or implemented. Yet despite these positive developments Europe faces growing social unrest over its austerity programs and a challenging economic environment with public sector spending eclipsing private sector growth. National elections scheduled in Italy for the first quarter of the year and Germany in the third or fourth quarter of the year adds to the uncertainty and depending on the outcome could lead to changes in Europe’s approach to the sovereign debt crisis. In addition, Greece, following a 2012 restructuring continues to need monetary support and remains at risk of default, further restructuring and/or exit from the Eurozone.
The following is an analysis of our AFS and HTM fixed maturity investment exposures related to GIIPS at December 31, 2012 and December 31, 2011 and the contractual maturities of these securities. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
As described in Item 1, Note 3, “Fair Value Measurements,” to the Consolidated Financial Statements included herein, effective January 1, 2008, we adopted the authoritative guidance on fair value measurements and, accordingly, have provided required disclosures by level within the fair value hierarchy of our assets and liabilities that are carried at fair value. As defined in the hierarchy, those assets and liabilities categorized as Level 3 have valuations determined using unobservable inputs. Unobservable inputs may include the entity’s own assumptions about market participant assumptions, applied to a modeled valuation, however, this is not the case with respect to our Level 3 assets and liabilities. The vast majority of the assets and liabilities classified as Level 3 are made up of securities for which we obtained values from brokers where significant inputs were utilized in determining the value that were difficult to corroborate with observable market data, sufficient information regarding the specific inputs utilized by the broker were not obtained to support a Level 2 classification or we utilized internal valuation models.
In addition, we assess the effectiveness of valuation controls performed by external parties responsible for sourcing appropriate valuations from third parties on our behalf. The approaches taken by these external parties to gain comfort include, but are not limited to, comparing valuations between external sources, completing recurring reviews of third party pricing services’ methodologies and reviewing controls of the third party service providers to support the completeness and accuracy of the prices received. 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.
Refer to Item 1, Note 3, “Fair Value Measurements,” of the Consolidated Financial Statements included herein, for a description of the valuation methodology utilized to value Level 3 assets and liabilities, how the valuation methodology is validated as well as further details associated with various assets classified as Level 3. At December 31, 2012, we did not have any liabilities that were carried at fair value based on Level 3 inputs other than derivative instruments in a liability position at December 31, 2012.
At December 31, 2012, our Level 3 assets represented approximately 2.9% of assets that are measured at fair value and less than 2% of total assets. Our Level 3 liabilities represented approximately 42.2% of liabilities that are measured at fair value and less than 1% of total liabilities at December 31, 2012.
other reserving techniques to project the estimated ultimate net liability for losses and loss expenses. Our reserving practices and the establishment of any particular reserve reflects our judgment concerning sound financial practice and do not represent any admission of liability with respect to any claims made against us.
Unpaid losses and loss expenses totaled $20.5 billion and $20.6 billion at December 31, 2012 and 2011, respectively. The table below represents a reconciliation of our P&C unpaid losses and loss expenses for the year ended December 31, 2012:
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 balance sheet 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 amounts due. Of the $3.4 billion total unpaid losses and loss expenses recoverable and reinsurance balances receivable at December 31, 2012, one individual reinsurer accounted for greater than 15% of the total. We are the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $1.7 billion at December 31, 2012, collateralizing reinsurance recoverables with respect to certain reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify us primarily because of disputes under reinsurance contracts and insolvencies. At December 31, 2012 and 2011, we had a reserve for potential non-recoveries from reinsurers of $108.0 million and $99.2 million, respectively.
Approximately 91% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (net of collateral held) outstanding at December 31, 2012 was due from reinsurers with a
financial strength rating of “A” or better. The following is an analysis of the total recoverable and reinsurance balances receivable at December 31, 2012, by reinsurers owing 3% or more of such total:
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long-term cash requirements of our business operations. As a global insurance and reinsurance company, one of our principal responsibilities to clients is to ensure that we have ready access to funds with which to settle large unforeseen claims. We would generally expect that positive cash flow from operations (underwriting activities and investment income) will be sufficient to cover cash outflows under most future loss scenarios. However, there is a possibility that unforeseen demands could be placed on us due to extraordinary events and, as such, our liquidity needs may change. Such events include, among other things: several significant catastrophes occurring in a relatively short period of time resulting in material incurred losses; rating agency downgrades of our core insurance and reinsurance subsidiaries that would require posting of collateral in connection with our letter of credit and revolving credit facilities; return of unearned premiums and/or the settlement of derivative transactions and large scale uncollectible reinsurance recoverables on paid losses (as a result of coverage disputes, reinsurers’ credit problems or decreases in the value of collateral supporting reinsurance recoverables). Any one or a combination of such events may cause a liquidity strain for us. In addition, a liquidity strain could also occur in an illiquid market, such as that which was experienced in 2008. Investments that may be used to meet liquidity needs in the event of a liquidity strain may not be liquid, due to inactive markets or may have to be sold at a significant loss as a result of depressed prices. Because each subsidiary focuses on a more limited number of specific product lines than is collectively available from the consolidated group of companies, the mix of business tends to be less diverse at the subsidiary level. As a result, the probability of a liquidity strain, as described above, may be greater for individual subsidiaries than when liquidity is assessed on a consolidated basis. If such a liquidity strain were to occur in a subsidiary, XL-Ireland may be required to contribute capital to the particular subsidiary and/or curtail dividends from the subsidiary to support holding company operations, which may be difficult given that XL-Ireland is a holding company and has limited liquidity.
certain “in use” portions of these facilities. Specifically, a downgrade below “A -” by A.M. Best would constitute an event of default under our three largest credit facilities and may trigger such collateral requirements. In certain limited instances, such downgrades may require that we return cash or assets to counterparties or to settle derivative and/or other transactions with the respective counterparties. See Item 1A, “Risk Factors,” included herein.
XL-Ireland’s and XL-Cayman’s future cash flows largely depend on the availability of dividends or other permissible payments from subsidiaries to make principal and interest payments on debt, to pay operating expenses and ordinary and preferred shareholder dividends, to make capital investments in subsidiaries and to pay other obligations that may arise from time to time. The ability of our subsidiaries to pay dividends to us or return capital from shareholders’ equity is limited by applicable laws and regulations of the various jurisdictions in which we operate, certain additional required regulatory approvals and by financial covenants contained in our letters of credit and revolving credit facilities. The payment of dividends to the holding companies by the Company’s principal operating subsidiaries is regulated under the laws of various jurisdictions including Bermuda, the U.K., Ireland and Switzerland, certain insurance statutes of various states in the United States in which the principal operating subsidiaries are licensed to transact business, the other jurisdictions where the Company has regulated subsidiaries and by regulations of the Society of Lloyd’s. See Item 8, Note 23, “Statutory Financial Data,” to the Consolidated Financial Statements for further discussion and details regarding the dividend capacity of our major operating subsidiaries. See also Item 1A, “Risk Factors - Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends, make payments on our debt securities and make other payments,” included herein. No assurance can be given that our subsidiaries will pay dividends in the future to XL-Ireland and XL-Cayman.
All of our outstanding debt at December 31, 2012 was issued by XL-Cayman. At December 31, 2011, all outstanding debt was issued by XL-Cayman except for the $600 million par value 6.5% Guaranteed Senior Notes (the “XLCFE Notes”) which were issued by XL Capital Finance (Europe) plc (“XLCFE”) and were repaid at maturity on January 15, 2012. Both XL-Cayman and XLCFE are 100% owned subsidiaries of XL-Ireland. The XLCFE Notes were fully and unconditionally guaranteed by XL Company Switzerland GmbH. XL-Cayman’s outstanding debt is fully and unconditionally guaranteed by XL-Ireland. The ability of XL- Cayman, like that of the Company’s, to obtain funds from its subsidiaries to satisfy any of its obligations under guarantees is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which we operate, including, among others, Bermuda, the United States, Ireland, Switzerland and the U.K. For details of the required statutory capital and surplus for our principal operating subsidiaries, see Note 23, “Statutory Financial Data.”
See also the Consolidated Statements of Cash Flows in Item 8, Financial Statements included herein.
At December 31, 2012, on a consolidated basis we had cash and cash equivalents of approximately $2.6 billion as compared to approximately $3.8 billion at December 31, 2011. The reduction was primarily due to the accumulation of cash in 2011 to fund the repayment of the XLCFE Notes in January 2012. We have three main sources of cash flows - those provided by operations, investing activities and financing activities:
Net cash used in investing activities was $942.6 million in the year ended December 31, 2012 compared to net cash provided of $832.1 million for the same period in 2011. These cash flows were associated with the normal purchase and sale of portfolio investments.
Certain of our invested assets are held in trust and pledged in support of insurance and reinsurance liabilities as well as credit facilities. Such pledges are largely required by our operating subsidiaries that are “non-admitted” under U.S. state insurance regulations, in order for the U.S. cedant to receive statutory credit for reinsurance. Also, certain deposit liabilities and annuity contracts require the use of pledged assets. As further described in Item 1, Note 5, “Investments - Pledged Assets,” to the Consolidated Financial Statements included herein, certain assets of the investment portfolio are pledged as collateral under our letter of credit facilities. At December 31, 2012 and December 31, 2011, we had $16.9 billion and $17.2 billion in pledged assets, respectively.
Cash flows related to financing activities include ordinary and preferred share related transactions, the payment of dividends, the issue or repayment of preference ordinary shares and deposit liability transactions. During the year ended December 31, 2012, net cash flows used in financing activities were
$1.3 billion. Net cash outflows related primarily to the buybacks of XL-Ireland’s ordinary shares and repayment of debt as described below.
On January 15, 2012, the $600 million principal amount outstanding on the XLCFE Notes, which were issued by XLCFE, was repaid at maturity. For further detail, see Item 1, Note 13, “Notes Payable and Debt Financing Arrangements,” to the Consolidated Financial Statements included herein.
sufficient capital to maintain its financial strength and credit ratings, as issued by several ratings agencies, at levels considered necessary by management to enable our key operating subsidiaries to compete;
The following risks are associated with our requirement to renew its credit facilities:
we may be downgraded by one or more rating agencies, which could materially and negatively impact our business, financial condition, results of operations and/or liquidity; and
The following tables present our debt under outstanding securities and lenders’ commitments at December 31, 2012:
“In Use/Outstanding” data represent December 31, 2012 accreted values. “Payments Due by Period” data represents ultimate redemption values.
In addition, see Item 1, Note 13, “Notes Payable and Debt and Financing Arrangements,” to the Consolidated Financial Statements included herein for further information.
At December 31, 2012, banks and investors provided us with $2.7 billion of debt capacity, of which $1.7 billion was utilized. These facilities consist of:
senior unsecured notes of approximately $1.7 billion. These notes require XL-Cayman to pay a fixed rate of interest during their terms. At December 31, 2012, there were four outstanding issues of senior unsecured notes:
$350 million senior notes due November 2024, with a fixed coupon of 6.375%. The security is publicly traded. The notes were issued at 100.0% and net proceeds were $347.8 million. Related expenses of the offering amounted to $2.2 million.
Neither the Redeemable Series C preference ordinary shares nor the Series E preference ordinary shares were transferred from XL-Cayman to XL-Ireland in the Redomestication. Accordingly, subsequent to July 1, 2010, these instruments represent non-controlling interests in our consolidated financial statements and have been reclassified to non-controlling interest in equity of consolidated subsidiaries. See Item 8, Note 1, “General,” to the Consolidated Financial Statements included herein for further information. During the third quarter of 2011, all Redeemable Series C preference ordinary shares were purchased and canceled. At December 31, 2012, the face value of the outstanding Series E preference ordinary shares was $999.5 million.
At December 31, 2012, we had five letter of credit (“LOC”) facilities in place with total availability of $4.0 billion, of which $1.8 billion was utilized.
We have the option to increase the size of the March 2011 Credit Agreement by an additional $500 million.
This letter of credit facility includes $1.0 billion that is also included in the “4-year revolver” listed under Debt.
We have the option to increase the size of the facilities under the December 2011 Credit Agreements by an additional $500 million across both such facilities.
In 2011, we (i) entered into three new credit agreements, which provided for an aggregate amount of outstanding letters of credit and revolving credit loans up to $3 billion, subject to certain options to increase the size of the facilities, and (ii) terminated the five-year credit agreement dated June 21, 2007 (the “2007 Credit Agreement”), which had provided for an aggregate amount of outstanding letters of credit and revolving credit loans up to $4 billion.
On March 25, 2011, we entered into a secured credit agreement (the “March 2011 Credit Agreement”) that currently provides for the issuance of letters of credit in an aggregate amount of up to $1 billion with the option to increase the size of the facility by an additional $500 million. Concurrent with the effectiveness of the March 2011 Credit Agreement, the commitments of the lenders under the 2007 Credit Agreement were reduced from $4 billion to $3 billion. The commitments under the March 2011 Credit Agreement will expire on, and the credit facility is available on a continuous basis until, the earlier of (i) March 25, 2014 and (ii) the date of termination in whole of the commitments upon an optional termination or reduction of the commitments by the account parties or upon an event of default.
As noted in the table above, at December 31, 2012, we were in compliance with all covenants by significant margins, and we currently remain in compliance.
instances, such downgrades may require us to return cash or assets to counterparties or to settle derivative and/or other transactions with the respective counterparties. See Item 1A, “Risk Factors - A downgrade or potential downgrade in our financial strength and credit ratings by one or more rating agencies could materially and negatively impact our business, financial condition, results of operations and/or liquidity.”
Future policy benefit reserves related to Life operations were $4.8 billion on our Consolidated Balance Sheet at December 31, 2012. 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.
We invest in CDOs and other investment vehicles that are issued through variable interest entities as part of our investment portfolio. The activities of these VIEs are generally limited to holding the underlying collateral used to service investments therein. Our involvement in these entities is passive in nature and we are not the arranger of these entities. We have not been involved in establishing these entities. We are not the primary beneficiary of these variable interest entities as contemplated in current authoritative accounting guidance.
We have a limited number of remaining outstanding credit enhancement exposures, including written financial guarantee and credit default swap contracts. The obligations related to these transactions are often securitized through variable interest entities. We are not the primary beneficiary of these variable interest entities as contemplated in current authoritative accounting guidance. For further details on the nature of the obligations and the size of our maximum exposure see Item 8, Note 14, “Derivative Instruments,” and Note 17(h), “Commitments and Contingencies - Financial and Other Guarantee Exposures,” to the Consolidated Financial Statements included herein.
The agreements provided us with a reinsurance collateral account in support of certain covered perils named in the reinsurance agreement. The covered perils include U.S. wind, European wind, California earthquake and terrorism worldwide. The contingent put option was recorded at fair value with changes in fair value recognized in earnings.
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2012, 2011 and 2010
Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010
Notes to Consolidated Financial Statements for the years ended December 31, 2012, 2011 and 2010
XL Group plc, through its operating subsidiaries (collectively the “Company” or “XL”), is a leading provider of insurance and reinsurance coverages to industrial, commercial and professional firms, insurance companies and other enterprises on a worldwide basis. The Company and its various subsidiaries operate globally in 24 countries, through its three business segments: Insurance, Reinsurance and Life operations. These segments are further discussed in Note 4, “Segment Information.”
Level 1-Quoted prices in active markets for identical assets or liabilities (unadjusted); no blockage factors.
Investments that are considered available for sale (comprised of the Company’s fixed maturities, equity securities and short-term investments) are carried at fair value. The fair values for available for sale 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
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 only payable to the Company when a security is called prior to its maturity are earned when received and reflected in net investment income.
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 may be required. 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 Level 2. Private equity investments are classified as Level 3. The net unrealized gain or loss on investments, net of tax, is included in “Accumulated other comprehensive income (loss).” Any
unrealized loss in value considered by management to be other-than-temporary is charged to income in the period that it is determined.
Overseas deposits include investments in private funds related to Lloyd’s syndicates in which the underlying instruments are primarily cash equivalents. The funds themselves do not trade on an exchange and therefore are not included within available for sale securities. Also included in overseas deposits are restricted cash and cash equivalent balances held by Lloyd’s syndicates for solvency purposes. Given the restricted nature of these cash balances, they are not included within the cash and cash equivalents line in the balance sheet. Each of these investment types is considered a Level 2 valuation.
The Company historically participated in structured transactions that include cash loans supporting project finance transactions, providing liquidity facility financing to a structured project deal in 2009 and the Company also invested in a payment obligation with an insurance company. These transactions are carried at amortized cost. For further details see Note 3, “Fair Value Measurements,” and Note 7, “Other Investments.”
In the normal course of business, the Company seeks 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. Reinsurance premiums ceded are expensed (and any commissions recorded thereon are earned) on a monthly pro-rata basis over the period the reinsurance coverage is provided. Ceded unearned reinsurance premiums represent the portion of premiums ceded applicable to the unexpired term of
policies in force. Mandatory reinstatement premiums ceded are recorded at the time a loss event occurs. 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.
The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. The changes in fair value of derivatives are shown in the consolidated statement of income as “net realized and unrealized gains and losses on derivative instruments” unless the derivatives are designated as hedging instruments. The accounting for derivatives which are designated as hedging instruments is discussed below. Changes in 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 sheet 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.
Derivative contracts can be exchange-traded or over-the-counter (“OTC”). Exchange-traded derivatives (futures and options) typically fall within Level 1 of the fair value hierarchy depending on whether they are deemed to be actively traded or not. OTC derivatives 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 pricing sources where an understanding of the inputs
The Company uses derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. These derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); or a hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract. In addition, the Company previously wrote a number of resettable strike swaps contracts relating to an absolute return index and diversified basket of funds, all of which are recorded within Investment Related Derivatives - Financial Market Exposures. These resettable strike swaps all expired during 2011.
losses on derivative instruments.” Periodic derivative net coupon settlements are recorded in net investment income. The Company may designate cash flow hedging relationships where interest rate swaps are used to mitigate interest rate risk associated with anticipated issuances of debt or other forecasted transactions.
Contracts entered into by the Company that are not deemed to transfer significant underwriting and/or timing risk are accounted for as deposits, whereby liabilities are initially recorded at an amount equal to the assets received. The Company uses a portfolio rate of return of equivalent duration to the liabilities in determining risk transfer. An initial accretion rate is established based on actuarial estimates whereby the deposit liability is increased to the estimated amount payable over the term of the contract.
amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The deferral of tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts and the period for which losses may be carried forward. A valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. The Company continues to evaluate income generated in future periods by its subsidiaries in different jurisdictions in determining the recoverability of its deferred tax asset. If it is determined that future income generated by these subsidiaries is insufficient to cause the realization of the net operating losses within a reasonable period, a valuation allowance is established at that time.
The Company adopted authoritative guidance on the fair value recognition provisions for accounting for stock-based compensation, under the prospective method for options granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for options under the disclosure-only provisions of the guidance and no stock-based employee compensation cost was included in net income as all options granted had an exercise price equal to the market value of the Company’s ordinary shares on the date of the grant. At December 31, 2012, the Company had several stock-based Performance Incentive Programs, which are described more fully in Note 18, “Share Capital.” Stock-based compensation issued under these plans generally has a life of not longer than ten years and vests as set forth at the time of grant. Awards currently vest annually over three or four years from the date of grant. The Company recognizes compensation costs for stock-based awards on a straight-line basis over the requisite service period (usually the vesting period) for each award.
In October 2010, the FASB issued an accounting standards update to address disparities in practice regarding the interpretation of which costs relating to the acquisition of new and renewal insurance contracts qualify for deferral. The provisions of the guidance specify that only costs that are related directly to the successful acquisition of new and renewal insurance contracts may be capitalized. These include incremental direct costs of contract acquisition and certain other costs related directly to underwriting activities. Incremental direct costs of contract acquisition are those that result directly from and are essential to a contract transaction, and would not have been incurred by the insurance entity had the transaction not occurred. Administrative costs, rent, depreciation, occupancy, equipment and all other general overhead costs are considered indirect costs and should be charged to expense as incurred. On January 1, 2012, the
Company adopted this guidance on a retrospective basis for all fiscal years presented, and interim periods within those years. The impact of adoption was a reduction in deferred acquisition costs of approximately $21 million, a reduction in deferred tax liabilities of approximately $7 million, and a corresponding reduction in opening retained earnings of approximately $14 million within the Company’s December 31, 2011 balance sheet. The adoption of this guidance did not have an impact on the Company’s consolidated statements of income or comprehensive income.
In June 2011, the FASB issued an accounting standards update concerning the presentation of comprehensive income in financial statements. This guidance allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. This guidance eliminates the option to present the components of other comprehensive income only as part of the statement of changes in shareholders’ equity. The guidance does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. The Company adopted the guidance from January 1, 2012; however, it did not have an impact on the Company’s disclosure, financial condition or results of operations or cash flows. In February 2013, the FASB issued an additional accounting standards update related to this topic that requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. The guidance does not change the current requirements for reporting net income or other comprehensive income in financial statements. These amendments are effective prospectively from January 1, 2013. As this guidance is disclosure-related only, its adoption will not impact the Company’s financial condition, results of operations, or cash flows.
In September 2011, the FASB issued an accounting standards update to simplify how entities test goodwill for impairment, by allowing an entity the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting entity is less than its carrying amount, as a basis for determining whether it is necessary to perform the two-step goodwill impairment test required under U.S. GAAP accounting rules. After assessing the circumstances that should be considered in making the qualitative assessment, if an entity determines that the fair value of a reporting unit as compared to its carrying value meets the threshold, then performing the two-step impairment step is unnecessary. In other circumstances, performance of the two-step test is required. The guidance also eliminates the option for an entity to carry forward its detailed calculation of a reporting unit’s fair value in certain situations. The Company adopted this guidance from January 1, 2012. It did not have an impact on the Company’s consolidated financial condition, results of operations, or cash flows.
In December 2011, the FASB issued an accounting standards update requiring additional disclosures about financial instruments and derivatives that are either: (1) offset for balance sheet presentation purposes or (2) subject to an enforceable master netting arrangement or similar arrangement, regardless of whether they are offset for balance sheet presentation purposes. In January 2013, the FASB issued an additional accounting standards update related to this topic clarifying that the disclosures would apply only to derivatives, repurchase and reverse repurchase agreements, and securities borrowing and securities lending transactions, each to the extent that they met one of the two conditions provided in the initial accounting standard. This guidance will be effective on January 1, 2013, with retrospective presentation of the new disclosures required. As this guidance is disclosure-related only and does not amend the existing balance sheet offsetting guidance, the adoption of this guidance will not impact the Company’s financial condition, results of operations, or cash flows.
The following tables set forth the Company’s assets and liabilities that were accounted for at fair value at December 31, 2012 and December 31, 2011 by level within the fair value hierarchy. For further information, see Note 2 (b), “Significant Accounting Policies - Fair Value Measurements”:
The Company invests in covered bonds issued by financial institutions (“Covered Bonds”). Covered Bonds are senior secured debt instruments issued by financial institutions and backed by over-collateralized pools of public sector or mortgage loans. At December 31, 2012, Covered Bonds within Total fixed maturities with a fair value of $647.1 million are included within Other
asset-backed securities to align the Company’s classification to market indices. At December 31, 2011, Covered Bonds within Total fixed maturities with a fair value of $353.9 million were reclassified from Corporate to Other asset-backed securities to conform to current period presentation.
The tables below present additional information about assets and liabilities measured at fair value on a recurring basis and for which Level 3 inputs were utilized to determine fair value. The tables present a reconciliation of the beginning and ending balances for the year ended December 31, 2012 and 2011 for all financial assets and liabilities measured at fair value using significant unobservable inputs (Level 3) at December 31, 2012 and 2011, 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, 2012 and 2011. 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.
There were no significant transfers between Level 1 and Level 2 during the years ended December 31, 2012 and 2011.
The remainder of the Level 3 assets relate to primarily to private equity investments and certain derivative positions as described below.
Included within the Other investments component of the Company’s Level 3 valuations are private investments and alternative fund investments over which the Company is not deemed to have significant influence. 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 nature of 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 and, accordingly, the fair value of the Company’s investment in each entity is classified within Level 3. The Company has not adjusted the net asset values received; however, management 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 in recording the fair value of each position. Investments in alternative funds included in Other investments utilize strategies including arbitrage, directional, event driven and multi-style. These 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 7, “Other Investments,” for further details.
Derivative instruments recorded within Other liabilities and classified within Level 3 include credit derivatives that provide 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 (“GMIB”) 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.
The Company evaluates the performance of both the Insurance and Reinsurance segments based on underwriting profit while the Life operations segment performance is based on contribution. Other items of revenue and expenditure of the Company are not evaluated at the segment level. In addition, the Company does not allocate investment assets by segment for its Property and Casualty (“P&C”) operations. Investment assets related to the Company’s Life operations and certain structured products included in the Insurance and Reinsurance segments and Corporate are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from the applicable segment.
Net fee income and other includes operating expenses from the Company’s loss prevention consulting services business.
The net results from P&C and Corporate structured products include net investment income, interest expense and operating expenses of $69.0 million, $52.9 million and $1.6 million (credit) and $12.5 million, $1.7 million and $1.0 million, respectively.
The cost (amortized cost for fixed maturities and short-term investments), fair value, gross unrealized gains and gross unrealized (losses), including, OTTI recorded in accumulated other comprehensive income (“AOCI”) of the Company’s available for sale (“AFS”) and held to maturity (“HTM”) investments at December 31, 2012 and December 31, 2011 were as follows:
Covered Bonds within Fixed maturities - AFS with an amortized cost of $345.4 million and a fair value of $353.9 million and Covered Bonds within Fixed maturities - HTM with an amortized cost of $8.1 million and a fair value of $7.7 million at December 31, 2011 have been reclassified from Corporate to Other asset-backed securities to align the Company’s classification to market indices and conform to current period presentation.
The contractual maturities of AFS and HTM fixed income securities at December 31, 2012 and December 31, 2011 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Under final authoritative accounting guidance, a debt security for which amortized cost exceeds fair value is deemed to be other-than-temporarily impaired if it meets either of the following conditions: (a) the Company intends to sell, or it is more likely than not that the Company will be required to sell, the security before a recovery in value, or (b) the Company does not expect to recover the entire amortized cost basis of the security. Other than in a situation in which the Company has the intent to sell a debt security or more likely than not will be required to sell a debt security, the amount of the OTTI related to a credit loss on the security is recognized in earnings, and the amount of the OTTI related to other factors (e.g., interest rates, market conditions, etc.) is recorded as a component of OCI. The net amount recognized
Included within Corporate are certain medium term notes supported primarily by pools of European investment grade credit with varying degrees of leverage. The notes, which are in a gross unrealized loss position, have a fair value of $194.3 million and an amortized cost of $194.8 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.
Covered Bonds within Fixed maturities and short-term investments - AFS with a fair value of $647.1 million and Covered Bonds within Fixed Maturities - HTM with a fair value of $8.6 million have been included within Other asset-backed securities to align the Company’s classification to market indices. Covered Bonds were included in Corporate prior to January 1, 2012.
Covered Bonds within Fixed maturities and short-term investments - AFS with a fair value of $353.9 million and Covered Bonds within Fixed Maturities - HTM with a fair value of $7.7 million have been included within Other asset-backed securities to align the Company’s classification to market indices and to conform to current period presentation. Covered Bonds were included in Corporate prior to January 1, 2012.
Included within equity securities are investments in fixed income funds with a fair value of $91.6 million and an amortized cost of $100.0 million at December 31, 2011.
Net investment income for the years ended December 31 is derived from the following sources:
The following represents an analysis of net realized gains (losses) and the change in unrealized gains (losses) on investments for the years ended December 31:
not sufficient to support the previously reported amortized cost. We also adjusted the estimated remaining holding period of certain notes resulting in a shorter reinvestment spectrum.
During the year ended December 31, 2012 and 2011, the $114.1 million and $209.2 million, respectively, of credit loss impairments previously recognized on securities that matured, or were paid down, prepaid or sold, includes $56.9 million and $128.9 million, respectively, of non-Agency RMBS.
The Company’s investment portfolio includes certain investments over which the company is considered to have significant influence and which, therefore, are accounted for using the equity method. Significant influence is generally deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or more in closed end funds, limited partnerships, LLCs or similar investment vehicles. The Company generally records its alternative and private equity fund affiliates on a one-month and three-month lag, respectively, and its operating affiliates on a three-month lag. See Note 7, “Other Investments” for investments in alternative and private equity funds in which the Company generally owns less than 3% and are accounted for as “Other Investments.”
Investments in affiliates comprised the following at December 31, 2012 and 2011:
these investments in funds, partnerships and other vehicles are classified as “investment fund affiliates.” The Company’s equity investment in investment fund affiliates and equity in net income (loss) from such affiliates as well as certain summarized financial information of the investee as a whole (shown as “Combined Funds”) are included below:
The carrying value of the Company’s holdings in funds that are subject to lockups and/or that have gate provisions in their governing documents as at December 31, 2012 and 2011 was $302.4 million and $419.4 million, respectively. The carrying value of the Company’s holdings in funds where a gate was imposed at December 31, 2012 and 2011 was $1.4 million and nil, respectively.
Certain funds may be allowed to invest a portion of their assets in illiquid securities, such as private equity or convertible 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, 2012 and 2011, the carrying value of our funds held in
The fair value of the Company’s holdings in funds that may be subject to lockups and/or that have gate provisions in their governing documents at December 31, 2012 and 2011 was $335.2 million and $240.0 million, respectively. The Company did not have any holdings in funds where a gate was imposed at December 31, 2012 or 2011.
Overseas deposits include investments in private funds related to Lloyd’s syndicates in which the underlying instruments are primarily government and government-related/supported and corporate fixed income securities. The funds themselves do not trade on an exchange and therefore are not included within available for sale securities. Also included in overseas deposits are restricted cash and cash equivalent balances held by Lloyd’s syndicates for solvency purposes. Given the restricted nature of these cash balances, they are not included within the cash and cash equivalents category in the balance sheet.
Surveillance procedures are conducted over each structured project finance loan on an ongoing basis with current expectations of future collections of contractual interest and principal used to determine whether any allowance for loan losses may be required at each period end. If it is determined that a future credit loss on a specific contract is reasonably possible and an amount can be estimated, an allowance is recorded. The contractual receivable is only charged off when the final outcome is known and the Company has exhausted all commercial efforts to try and collect any outstanding balances.
On June 9, 2009, XL Specialty Insurance Company (“XL Specialty”), a wholly-owned subsidiary of the Company, entered into an agreement with National Indemnity Company, an insurance company subsidiary of Berkshire Hathaway Inc. (“National Indemnity”). Under the agreement, and a related reinsurance agreement, National Indemnity would issue endorsements (“Endorsements”) to certain directors and officers liability insurance policies known as “Side A” coverage policies underwritten by XL Specialty (the “Facility”) during an eighteen month period that ended in December 31, 2011.
In connection with the Facility, XL Insurance (Bermuda) Ltd (“XLIB”) purchased a payment obligation (the “Obligation”) in an aggregate principal amount of $150 million from National Indemnity. The outstanding Obligation was recorded in Other Investments at an estimated fair value of $128.1 million, pays a coupon of 3.5%, and is being accreted to $150 million over the 11.5 year 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. During the years ended December 31, 2012, 2011 and 2010, amortization of nil, $9.4 million and $9.5 million, respectively, was recorded.
On July 17, 2009, XLIB, a wholly-owned subsidiary of the Company, purchased notes with an aggregate face amount of $155 million. The carrying value of these notes at December 31, 2012 and 2011 was $147.8 million and $147.5 million, respectively. The issuer of the notes is a structured credit vehicle that holds underlying assets including corporate debt and preferred equity securities, including some securities issued by European financial institutions, as well as project finance debt securities. The notes, which are callable under certain criteria, have a final maturity of July 22, 2039.
These structured transactions are not considered to be fair value measurements under U.S. GAAP and, accordingly, they have been excluded from the fair value measurement disclosures. See Note 3, “Fair Value Measurements,” for details surrounding the estimated fair value of these investments.
The Company regularly reviews the performance of these other investments. The Company recorded losses of $2.7 million, $0.7 million and $7.8 million in the years ended December 31, 2012, 2011 and 2010, respectively, due to other than temporary declines in values of these other investments.
The following table presents an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2012, 2011 and 2010:
The Company tests goodwill for impairment on an annual basis as of June 30, during the third quarter, and on an interim basis when certain events or circumstances exist. The Company tests for impairment at the reporting unit level in accordance with the authoritative guidance on intangibles and goodwill. For the Reinsurance segment, a reporting unit is one level below the business segment, while for Insurance, the segment is also the reporting unit. The first step is to identify potential impairment by comparing the estimated fair value of a reporting unit to its estimated book value, including goodwill. The fair value of each reporting unit is derived based upon valuation techniques and assumptions the Company believes market participants would use to value the business and this is then compared to the book value of the business. The Company derives the net book value of its reporting units by estimating the amount of shareholders’ equity required to support the activities of each reporting unit. The estimated fair values of the reporting units are generally determined utilizing methodologies that incorporate price-to-net-tangible-book and price-to-earnings multiples of certain comparable companies in the industry, from an operational and economic standpoint. If such individual reporting unit estimated fair values - combined with an estimate of an appropriate control premium - exceed their related individual reporting unit net book values, goodwill for those individual reporting units is not deemed to be impaired. A control premium represents the value an investor would pay above non- controlling interest transaction prices in order to obtain a controlling interest in the respective company.
However, if the margin calculated between the estimated reporting unit fair value and its net book value indicates a potential impairment or a “close call”, a further analysis of the reporting unit’s estimated fair value is performed, using an entity-specific discounted cash flow methodology. This methodology establishes fair value by estimating the present value of the projected future cash flows to be generated from the reporting unit. The discount rate applied to the projected future cash flows to arrive at the present value is intended to reflect all risks of ownership and the associated risks of realizing the stream of projected future cash flows. The discounted cash flow methodology uses the Company’s projections of
During the third quarter of 2011, the Company completed its annual goodwill impairment testing based on Company and industry data as of June 30, 2011, which ultimately did not result in any goodwill impairments being recorded by the Company. Although the results of this analysis did not indicate the need for any impairment charges, management evaluated the sensitivity of the fair value calculations in the goodwill impairment test and concluded that relatively small changes to key assumptions such as discount rate, the terminal value, expected future revenues, gross margins and operating margins could result in a calculated fair value insufficient to support the current level of goodwill in certain businesses. Management also concluded that the prolonged weakened market conditions resulted in the range of calculated fair values used for testing impairment in the reporting units being sufficiently close to the current net book values to warrant quarterly analysis until market conditions improve.
At December 31, 2011, the Company updated its impairment analytics utilizing all of the methodologies discussed above. As a result of the analysis performed, the Company concluded that the indicated ranges of fair values of the reporting units within the Reinsurance segment in which goodwill is carried was sufficient to support their goodwill balances; however, the indicated fair value of the Insurance segment reporting unit was not sufficient to support its goodwill balance, and thus did not pass step one of the impairment testing process. Therefore step two was required to quantify the amount of goodwill impairment. Following the step two valuation process, the $429 million carrying value of goodwill was deemed to be impaired. As a result of the continued losses in certain businesses within the segment and continued low industry market valuations, the Company increased the rate of return a market participant would require from that used in previous goodwill testing and decreased the level of control premiums added to market value multiples for the insurance reporting unit. These factors taken together, led to the conclusion that the impairment was required. The assumptions utilized within the Reinsurance segment reporting unit valuations were not modified from those utilized during the third quarter as these units were not impacted by similar underperformance.
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 collectability 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 total allowance recorded relating to reinsurance balances receivable was $54.6 million and $43.9 million at December 31, 2012 and 2011, respectively.
creditworthiness of the Company’s reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than the Company’s bad debt provision. Such an event could have a material adverse effect on the Company’s financial condition, results of operations, and cash flows.
Approximately 91% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (net of collateral held) outstanding at December 31, 2012 was due from reinsurers with a financial strength rating of “A” or better. The following is an analysis of the total recoverable and reinsurance balances receivable at December 31, 2012, by reinsurers owing 3% or more of such total:
Unpaid losses and loss expenses for the indicated years ended December 31 are comprised of:
The following table represents an analysis of the Company’s paid and unpaid losses and loss expenses incurred and a reconciliation of the beginning and ending unpaid losses and loss expenses for the years indicated:
Net favorable prior year reserve development for the Insurance Segment of $140.1 million for the year ended December 31, 2012 was mainly attributable to the following:
For casualty lines, net prior year development during the year was $61.6 million favorable. This was driven by a release of $25.5 million in international primary casualty due to better than expected reported loss experience. The primary casualty releases relate to the 2006 to 2011 accident years. There was also a release of $50.7 million in the excess casualty lines due primarily to better than expected reported loss experience, the majority of which relates to the 2005 and prior accident years. The releases in primary and excess casualty were partially offset by an increase of $15.7 million in
In terms of non-clash losses in the core professional businesses, $18.2 million and $19.8 million was released from the U.S. and Bermuda books, respectively, due to better than expected reported loss experience while the International core book was strengthened by $39.5 million due to unfavorable reported loss experience. Although this led to a relatively immaterial $1.5 million strengthening in aggregate across the core professional businesses, this resulted in strengthening between the 2009 and 2011 report years offset by releases in the 2008 and prior report years.
Offsetting the above, the Design portfolio, covering architects’ and engineers’ professional liability, was strengthened by $22.9 million due to worse than expected reported loss experience in the Canadian book partially offset by a release of $9.6 million in the U.S. book as a result of favorable reported loss experience.
For specialty lines, net prior year development during the year was $61.8 million favorable. This was driven by releases of $44.0 million, $4.5 million and $4.0 million for the non-catastrophe exposures in aerospace, specie and product recall, respectively, due to continued better than expected reported loss experience in the more recent accident years. It was also driven by a release of $8.6 million in the London Market discontinued political risk book reflecting the limited remaining exposures on this mature portfolio.
For other lines, net prior year development during the year was $136.4 million unfavorable. Continued adverse reported loss experience in the excess and surplus lines led to a strengthening of $80.4 million between the 2006 and 2011 accident years. This was primarily driven by strengthening of $36.5 million and $38.4 million in the Apartments and New York Contractors books respectively. The discontinued surety book was strengthened by $44.9 million based on recent settlements while a claims audit led to an increase of $11.8 million in programs predominantly in the more recent accident years.
Net favorable prior year reserve development for the Insurance segment of $76.5 million (corresponding gross development was $23.1 million unfavorable) for the year ended December 31, 2011 was mainly attributable to releases of $87.5 million in professional lines, $71.3 million for specialty lines and $8.9 million for property lines partially offset by strengthening of $34.5 million for casualty lines and $56.7 million for other lines. The professional lines benefitted from releases in reserves for clash losses totaling $88.5 million. Better than expected reported loss experience in the marine, aerospace, specie and discontinued lines led to the release in the specialty lines while the property lines benefited from better than expected reported loss activity for the non-catastrophe exposures. The strengthening in the casualty lines mainly related to adverse development on large excess casualty claims associated with the Deepwater Horizon event in the 2010 accident year totaling $135.6 million gross and $33.4 million net. Adverse development in the excess and surplus lines and run-off surety book of business led to the unfavorable result in other lines.
Net favorable prior year reserve development for the Insurance segment of $127.4 million for the year ended December 31, 2010 was mainly attributable to releases of $118.6 million in professional lines, $66.3 million for specialty lines and $23.5 million for property lines partially offset by strengthening of $29.0 million for casualty lines and $52.0 million for other lines. The favorable professional lines result was driven by lower than expected actual losses in the core professional businesses totaling $216.3 million partially offset by unfavorable development of $63.7 million in the U.S. Private Commercial lines, $27.4 million in the Select portfolio and $6.2 million in the Design portfolio. Lower than expected actual losses in the aerospace, marine, specie, equine and discontinued lines led to the release in the specialty lines while the property lines benefited from lower than expected actual losses for the non-catastrophe exposures. The strengthening in the casualty lines was driven by unfavorable development of $45.1 million in the U.S. risk management lines and $15.5 million in the environmental lines partially offset by a $26.0 million decrease in the uncollectible reinsurance reserve from reduced exposures and lower estimated risk levels from the Swiss operations. An unfavorable settlement in the surety lines and an unfavorable commutation in the financial lines led to the adverse result in other lines.
Net favorable prior year reserve development for the Reinsurance segment of $175.8 million for the year ended December 31, 2012 was mainly attributable to the following:
Net favorable prior year development during the year of $68.2 million for the long-tailed lines and details of these by specific lines are as follows:
Net favorable prior year reserve development for the Reinsurance segment of $208.4 million for the year ended December 31, 2011 was attributable to a net favorable prior year development of $64.3 million for the short-tailed lines and a net favorable prior year development of $144.1 million for the long-tailed lines. The net favorable prior year development for short-tailed was explained by $37.3 million in favorable property catastrophe development, by $40.5 million in favorable property other lines releases and was partially offset by $13.5 million in unfavorable marine and aviation development. The net favorable prior year development for long-tailed lines was explained by $109.4 million in favorable casualty lines development and by additional $34.7 million in favorable other lines development mainly due to reserve releases on whole account treaties written on Lloyd’s syndicates for the 2008 underwriting year as well as releases on large losses and trade credit.
Total net paid losses were $3.8 billion, $3.8 billion and $3.5 billion in 2012, 2011 and 2010, respectively.
The Company’s net incurred losses and loss expenses include actual and estimates of potential non-recoveries from reinsurers. As at December 31, 2012 and 2011, the reserve for potential non-recoveries
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 5% in 2012 and 2011. The interest rate approximates the average yield to maturity on specific fixed income investments that support these 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 periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2012 and 2011 on an undiscounted basis were $645.2 million and $612.9 million, respectively. The related discounted unpaid losses and loss expenses were $343.0 million and $290.3 million at December 31, 2012 and 2011, respectively.
The Company’s exposure to discontinued asbestos and run-off environmental claims arises from the following three sources:
Total deposit liabilities were $1.6 billion for the years ended December 31, 2012 and 2011. Interest expense of $66.3 million, $51.3 million and $54.4 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2012, 2011 and 2010, respectively.
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 4.5% at December 31, 2012 and 2011. Total future policy benefit reserves for the year ended December 31, 2012 and 2011 were $4.8 billion. There were normal course releases on single premium annuities in line with the benefits paid and mortality of underlying policyholders, which has been partially offset by foreign exchange movements, resulting in a net decrease of $26.3 million during 2012.
Concurrent with the issuance of ordinary shares and pursuant to the Company’s shelf registration statement, the Company, in August 2008, issued 23.0 million 10.75% Equity Security Units (the “10.75% Units”) in a public offering in order to fund payments in relation to the Master Commutation Release and Restructuring Agreement, dated July 28, 2008, as amended among XL Insurance (Bermuda) Ltd (“XLIB”) and affiliates Syncora Holdings Ltd. and its affiliates (“Syncora”) and certain of Syncora’s credit default swap counterparties (the “Master Agreement”), and remaining net proceeds were used for general corporate purposes. The Company received approximately $557.0 million in net proceeds from the sale of the 10.75% Units after deducting underwriting discounts. Each 10.75% Unit had a stated amount of $25 and consisted of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Ordinary Shares on August 15, 2011 and (b) a one-fortieth, or 2.5%, ownership
On September 30, 2011, XL-Cayman issued $400 million aggregate principal amount of 5.75% Senior Notes due 2021 at the issue price of 100% of the principal amount. The 5.75% Senior Notes are fully and unconditionally guaranteed by XL-Ireland. The 5.75% Senior Notes bear interest at a rate of 5.75% per annum, payable semiannually, beginning on April 1, 2012, and mature on October 1, 2021. XL-Cayman may redeem the 5.75% Senior Notes, in whole or part, from time to time in accordance with the terms of the indenture pursuant to which the 5.75% Senior Notes were issued. XL-Cayman received net proceeds of approximately $395.7 million from the offering, which were used to partially repay the $600 million principal amount outstanding of the XLCFE Notes.
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized primarily to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. The Company’s letter of credit facilities and revolving credit facilities at December 31, were as follows:
The 2007 Credit Agreement had provided for letters of credit and for revolving credit loans of up to $750 million with the aggregate amount of outstanding letters of credit and revolving credit loans thereunder not to exceed $3 billion. At the time at which it was terminated and the December 2011 Credit Agreements became effective, there were no outstanding revolving credit loans under the 2007 Credit Agreement. A portion of the letters of credit outstanding under the 2007 Credit Agreement at the time of its termination was continued under the March 2011 Credit Agreement and the remainder was continued under the December 2011 Credit Agreements.
On August 3, 2010, a $100 million five-year revolving credit facility expired and was not replaced, and on June 22, 2010, a $2.3 billion five-year letter of credit facility expired and was not replaced.
In addition, the Company maintains off-balance sheet financing arrangements in the form of a contingent capital facility. For details of this facility, see Note 15, “Off-Balance Sheet Arrangements.”
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 guidelines established by management and the Risk and Finance Committee of the Company’s Board of Directors. The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value with the changes in fair value of derivatives shown in the consolidated statement of income as “net realized and unrealized gains and 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 2(h), “Significant Accounting Policies - Derivative
The periodic coupon settlements resulted in increases to Net investment income of nil, nil and $2.3 million for the years ended December 31, 2012, 2011 and 2010.
interest expense, over the remaining terms of the deposit liability contracts. At settlement, the weighted average term remaining to maturity for these contracts was 16.1 years.
The Company utilizes foreign exchange contracts to hedge the fair value of certain net investments in foreign operations. During the year ended December 31, 2012 and 2011, the Company entered into foreign exchange contracts that were formally designated as hedges of investments in foreign subsidiaries, the majority of which have functional currencies of either U.K. sterling 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 resultant gain (loss) that was recorded in the cumulative translation adjustment account within AOCI for the year ended December 31, 2012 and 2011.
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.
Stock index futures may be purchased within the Company’s investment portfolio in order to create synthetic equity exposure and to add value to the portfolio with overlay strategies where market inefficiencies are believed to exist. From time to time, the Company may enter into other financial market exposure derivative contracts on various indices including, but not limited to, inflation and commodity contracts.
At December 31, 2012, the Company held one credit derivative exposure, which was written as part of the Company’s previous financial lines business and is outside of the Company’s investment portfolio. This is a European project finance loan participation which benefits from an 80% deficiency guarantee from the German state and federal governments. At December 31, 2011, the Company held two credit derivative exposures, the European project finance loan already mentioned and a credit default swap that was executed in 2000 with underlying collateral being predominantly pools of leveraged loans and bonds, which were fully paid off during 2012, resulting in the Company’s release from its credit default swap. An aggregate summary of the credit derivative exposures at December 31, 2012 and December 31, 2011 is as follows:
At December 31, 2012 and December 31, 2011, there were no reported events of default on these obligations. Credit derivatives are recorded at fair value based upon prices received from the investment bank counterparties and corroborated by using models developed by the Company. Although the Company does not have access to the specific unobservable inputs that may have been used in the value provided by the counterparties, it expects that the significant inputs considered would include changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivatives are not traded to realize this resultant value.
The Company invests in CDOs and other investment vehicles that are issued through VIEs as part of the Company’s investment portfolio. The activities of these VIEs are generally limited to holding the underlying collateral used to service investments therein. The Company’s involvement in these entities is passive in nature and we are not the arranger of these entities. In addition, the Company has not been involved in establishing these entities and is not the primary beneficiary of these VIEs as contemplated in current authoritative accounting guidance.
The Company did not have an aggregate direct investment in any single corporate issuer in excess of 5% of shareholders’ equity at December 31, 2012 or December 31, 2011. 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 back securities that were issued, sponsored or serviced by the parent and government-guaranteed issues, but does include covered bonds.
In addition, the Company underwrites a significant amount of its insurance and reinsurance property and casualty business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During the three years ended December 31, 2012, 2011 and 2010, P&C gross written premiums generated from or placed by the below companies individually accounted for more than 10% of the Company’s consolidated gross written premiums from P&C operations, as follows:
These companies are large, well established companies and there are no indications that any of them are financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from P&C operations in any of the three years ended December 31, 2012, 2011 and 2010.
The Company owns a minority interest in certain closed-end funds, certain limited partnerships and similar investment vehicles, including funds managed by those companies. The Company has commitments, which include potential additional add-on clauses, to invest an additional $49.7 million over approximately the next five years.
During 2003, the Company entered into a purchase, sale and leaseback transaction to acquire new office space in London. The Company has recognized a capital lease asset of $98.5 million and $100.7 million, and deferred a gain of $29.9 million and $30.6 million related to this lease at December 31, 2012 and 2011, respectively. The gain is being amortized to income in line with the amortization of the asset. The future minimum lease payments in the aggregate are expected to be $222.4 million and annually for the next five years are as follows:
The Company and its subsidiaries are subject to litigation and arbitration in the normal course of business. These lawsuits and arbitrations principally involve claims on policies of insurance and contracts of reinsurance and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such claims proceedings are considered in connection with the Company’s loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof. In addition to litigation relating to insurance and reinsurance claims, the Company and its subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from or directly relate to claims on insurance or reinsurance policies. This category of business litigation typically involves, among other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, shareholder disputes or disputes arising from business ventures. The status of these legal actions is actively monitored by management.
If management believes that, based on available information, it is at least reasonably possible that a material loss (or additional material loss in excess of any accrual) will be incurred in connection with any legal actions, the Company discloses an estimate of the possible loss or range of loss, either individually or in the aggregate, as appropriate, if such an estimate can be made, or discloses that an estimate cannot be made. Based on the Company’s assessment at December 31, 2012, no such disclosures are considered necessary.
On June 28, 2010, the Company’s subsidiary, XLIB, completed a commutation, termination and release agreement (the “Termination Agreement”) with European Investment Bank (“EIB”) which fully extinguished and terminated all of the guarantees issued to EIB by XLIB in connection with financial guaranty policies between certain subsidiaries of Syncora Holdings and EIB. These guarantees were provided for the benefit of EIB relating to project finance transactions comprised of transportation, school and hospital projects with an average rating of BBB, written between 2001 and 2006 with anticipated maturities ranging between 2027 and 2038. The guarantees had been accounted for under Accounting Standards Codification (“ASC”) section 460-10, Guarantees (previously FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.”)
The authorized share capital of XL-Ireland is $9,999,900 and €40,000, divided into: (i) 500,000,000 ordinary shares, par value $0.01 each, (ii) 499,990,000 undesignated shares, par value $0.01 each and (iii) 40,000 subscriber shares, par value €1 each. Holders of ordinary shares are entitled to one vote for each share.
On February 12, 2010, the Company repurchased a portion of its outstanding Redeemable Series C preference ordinary shares, which resulted in approximately 4.4 million Series C preference ordinary shares with a liquidation value of $110.8 million being purchased by the Company for approximately $94.2 million. As a result, a book value gain of approximately $16.6 million was recorded in the first quarter of 2010 to ordinary shareholders.
On October 15, 2011, XL-Cayman issued $350 million Series D Preference Ordinary Shares for consideration of cash and liquid investments which were held in a trust account that was part of the Stoneheath facility. Holders of the Stoneheath Securities issued by Stoneheath in December 2006 received one Series D Preferred Share in exchange for each Stoneheath Security. Dividends on the Series D Preference Ordinary Shares are declared and paid quarterly at a floating rate of three-month LIBOR plus 3.120% on the liquidation preference. XL-Cayman used the consideration it received as partial funding for the repayment at maturity of the outstanding $600 million XLCFE Notes that were issued by XLCFE, with the balance available for general corporate purposes. For further details regarding Stoneheath, see Note 15, “Off-Balance Sheet Arrangements.” The Series D Preference Ordinary Shares represent non-controlling interests in equity of consolidated subsidiaries.
On December 5, 2011, the Company repurchased and held 5,000 of the outstanding Series D Preference Ordinary Shares with a liquidation preference value of $5.0 million for $3.7 million, including accrued dividends. As a result of these repurchases, the Company recorded a gain of approximately $1.3 million through Non-controlling interests in the Consolidated Statement of Income in the fourth quarter of 2011.
On March 15, 2007, the Company issued 1.0 million Fixed/Floating Series E Perpetual Non-Cumulative preference ordinary shares, par value $0.01 each, with liquidation preference $1,000 per share (the “Series E preference ordinary shares”). The Company received net proceeds of approximately $983.8 million from the offering. The Series E preference ordinary shares are perpetual securities with no fixed maturity date and are not convertible into any of the Company’s other securities. Dividends on the Series E preference ordinary shares are declared and paid semi-annually at a rate of $32.50 per share.
The Company’s performance incentive programs provide for grants of stock options, restricted stock, restricted stock units and performance units and stock appreciation rights. Share-based compensation granted by the Company generally contains a vesting period of three or four years, and certain awards also contain performance conditions. The Company records compensation expense related to each award over its vesting period, incorporating the best estimate of the expected outcome of performance conditions where applicable. Compensation expense is generally recorded on a straight line basis over the vesting period of an award.
Restricted stock awards issued under the 1991 Performance Incentive Program and the Directors Stock and Option Plan vest as set forth in the applicable award agreements. Each restricted stock award represents the Company’s obligation to deliver to the holder one ordinary share. The employees and directors who are granted a restricted stock award shall have all the rights of a shareholder, including the right to vote and receive dividends. These shares contained 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 1991 Performance Incentive Program and the Directors Stock and Option Plan for the three years ended December 31 is as follows:
Non-vested restricted stock awards at December 31, 2012 and for the year then ended for the Company were as follows:
Total unrecognized stock-based compensation expense related to non-vested restricted stock units was approximately $32.5 million as of the end of December 31, 2012, related to approximately 2.4 million restricted stock units, which is expected to be recognized over 1.3 years.
Non-vested restricted stock units as of December 31, 2012 and for the year then ended for the Company were as follows:
In addition, certain former employees have received benefit type guarantees, not formally a part of any established plan. The liability recorded with respect to these agreements as at both December 31, 2012 and 2011 was $3.3 million, respectively, representing the entire unfunded projected benefit obligations.
A contributory defined benefit pension scheme exists in the U.K. (the “Scheme”), but has been closed to new entrants since 1996. The Scheme has approximately 90 members, of whom approximately 55 are active or deferred members of the Scheme. Benefits are based on length of service and compensation as defined in the Trust Deed and Rules, and the Scheme is subject to triennial funding valuations, the most recent of which was conducted in 2010 and was reported in 2011. The $4.5 million deficit is being funded over a ten-year period. Current contribution rates are 24.6% and 3% of pensionable salary for employer and employee respectively.
Certain contributory defined benefit pension plans exist in several European countries, most notably Germany, which are closed to new entrants. Benefits are generally based on length of service and compensation defined in the related agreements. Included in the projected obligation amounts of $83.1 million and $72.3 million at December 31, 2012 and 2011, respectively, in the table below, are total unfunded projected obligations in relation to the European defined benefit schemes of $18.5 million and $14.6 million, respectively.
The status of all the Company’s retirement plans at December 31, 2012 and 2011 is as follows:
In 2012, four quarterly dividends of $0.11 per share were paid to all ordinary shareholders of record as of March 15, June 15, September 14 and December 14. In 2011, four quarterly dividends of $0.11 per share were paid to all ordinary shareholders of record as of March 15, June 15, September 15 and December 15. In 2010, four quarterly dividends of $0.10 per share were paid to all ordinary shareholders of record as of March 15, June 15, September 15 and December 15.
The Company paid dividends to Series C, Series D and Series E preference shareholders for the three years ended December 31, as follows:
At December 31, 2011, no Series C preference ordinary shares were outstanding.
The Company adopted the provisions of the final authoritative guidance on accounting for uncertainty in income taxes, on January 1, 2007. The Company did not recognize any liabilities for unrecognized tax benefits as a result of its implementation and has not recognized any liabilities in subsequent accounting periods. The Company’s policy is to recognize any interest accrued related to unrecognized tax benefits as a component of interest expense and penalties accrued related to unrecognized tax benefits in the tax charge. At December 31, 2012 and 2011, the Company has no accrued liabilities for tax, interest and penalties relating to unrecognized tax benefits.
The Company has open tax years that are potentially subject to examinations by local tax authorities, in the following major tax jurisdictions: the U.S. 2011 and 2012; the U.K., 2011 and 2012; Switzerland, 2008 to 2012; Ireland, 2008 to 2012; Germany, 2010 to 2012; and France, 2008 to 2012.
Significant components of the Company’s deferred tax assets and liabilities at December 31, 2012 and 2011 were as follows:
At December 31, 2012, the Company had realized capital loss carry forwards of approximately $282.8 million in the U.S. ($99.0 million tax effected). The 5 year limitation for the utilization of realized capital losses applies to this balance. Losses of $54.1 million will expire at the end of 2013 with another $228.7 million of realized capital losses expiring in future years through 2016. A valuation allowance ($99.0 million) has been established in respect of all of these realized capital losses. At December 31, 2012, the Company also had $278.8 million of U.S. capital losses arising from the sale of investments to a group company ($97.6 million tax effected), against which a valuation allowance of $97.6 million has been established. These losses cannot be utilized to offset any future U.S. realized capital gains, and will not begin to expire, until the underlying assets have been sold to unrelated parties.
Shareholders’ equity at December 31, 2012 and 2011 reflected tax benefits of nil and nil, respectively, related to compensation expense deductions for stock options exercised by the Company’s U.S. subsidiaries.
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 letters of credit and revolving credit facilities. The payment of dividends to XL-Ireland and XL-Cayman, the Company’s holding companies, 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 states in the United States in which the principal operating subsidiaries are licensed to transact business and the other jurisdictions where the Company has regulated subsidiaries. Statutory capital and surplus for the principal operating subsidiaries of the Company for the years ended December 31, 2012 and 2011 are summarized below:
Statutory net income (loss) for the principal operating subsidiaries of the Company for the years ended December 31, 2012, 2011 and 2010 is summarized below:
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 Re Ltd and XL Insurance (Bermuda) Ltd, under the BSCR are highlighted in the table above. In addition to the BSCR based requirements, the BMA also prescribes minimum liquidity standards which must be met.
Unless permitted by the New York Superintendent of Insurance, the Company’s lead property and casualty subsidiary in the United States (“XLRA”) may not pay dividends to shareholders in an aggregate amount in any twelve month period that exceeds the lesser of 10 percent of XLRA’s statutory policyholders’ surplus or 100 percent of its “adjusted net investment income,” as defined. The New York State insurance law also provides that any distribution that is a dividend may only be paid out of statutory earned surplus. At December 31, 2012 and 2011, XLRA had statutory earned surplus of $152.9 million and $59.7 million, respectively. At December 31, 2012, XLRA’s statutory policyholders’ surplus was $2.2 billion, and accordingly, the maximum amount of dividends XLRA can declare and pay in 2013, without prior regulatory approval, is $152.9 million. At December 31, 2012 and 2011, none of the seven property and casualty subsidiaries of XLRA had a statutory earned deficit.
The Company’s international principal operating subsidiaries prepare statutory financial statements based on local laws and regulations. Some jurisdictions impose enhanced regulatory requirements on insurance companies while other jurisdictions impose fewer requirements. In some countries, such subsidiaries must obtain licenses issued by governmental authorities to conduct local insurance business. These licenses may be subject to minimum reserves and minimum capital and solvency tests. Jurisdictions may impose fines, censure, and/or impose criminal sanctions for violation of regulatory requirements. The majority of the actual statutory capital outside of the U.S. and Bermuda is held in Ireland ($0.9 billion at December 31, 2012) and the U.K. ($1.0 billion at December 31, 2012). The Company’s Irish operating subsidiary, XL Re Europe public limited company is required to seek prior approval from the Irish regulator to reduce its share capital or to pay dividends.
The ability to declare and pay dividends may also be restricted by financial covenants in the Company’s letters of credit and revolving credit facilities. The Company was in compliance with all covenants by significant margins at December 31, 2012, and the Company currently remains in compliance.
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2012, 2011 and 2010:
During the first quarter of 2011, the Redeemable Series C preference ordinary shares were reclassified as Non-controlling interest - Redeemable Series C preference ordinary shares and Series E preference ordinary shares were reclassified as Non-controlling interest in equity of consolidated subsidiaries on the Company’s consolidated balance sheet as a result of changes in ownership structure arising as part of the Company’s Redomestication of the ultimate parent holding company to Ireland as of July 1, 2010. Accordingly, preference share dividends declared are recorded as Non-controlling interests rather than as Preference share dividends within the consolidated statements of income from July 1, 2010 onwards. See Note 1, “General,” for additional details. During the third quarter of 2011, all outstanding Redeemable Series C preference ordinary shares were repurchased and canceled.
For the years ended December 31, 2012, 2011 and 2010, ordinary shares available for issuance under share-based compensation plans of 8.7 million, 16.9 million and 12.8 million, respectively, were not included in the calculation of diluted earnings per share because the assumed exercise or issuance of such shares would be anti-dilutive.