The Company operates in Bermuda, the United States, Europe and various other locations around the world. In 1997, the Company acquired commercial real estate in Hamilton, Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The development was completed in April 2001. The total cost of this development, including land, was approximately $126.6 million.
The Company operates on a global basis primarily in the property and casualty industry and, to a lesser extent, the financial services industry. The Company serves the insurance, reinsurance and financial services needs of institutional and corporate clients, typically the global equivalent of the Fortune 2000. The Company operates in markets where it believes its underwriting expertise and financial strength represent a relative advantage.
The Company has grown through acquisitions and development of new business opportunities. Acquisitions included Global Capital Re in 1997, Mid Ocean Limited in 1998, ECS, Inc. and NAC Re Corp. in 1999, Winterthur International in 2001 and Le Mans Ré in 2002. All acquisitions have supported the Company’s strategic plan to develop a global platform in insurance and reinsurance. Other business developments include XL Weather & Energy Inc., XL Life Insurance & Annuity Company and SCA which offers financial guaranty insurance and reinsurance products through XL Capital Assurance Inc. and XL Financial Assurance Ltd., respectively. As a result of these combined developments, the Company now competes as an integrated global business with more than 3,700 employees in 28 countries.
The property and casualty insurance and reinsurance markets have historically been cyclical, meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable to the Company (a “hard market”) and there have been periods where premium rates decline and policy terms and conditions are less favorable to the Company (a “soft market”). Market conditons are driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events. Management’s goal is to build long-term shareholder value by capitalizing on current opportunities and managing through any cyclical downturns by reducing its property and casualty book of business and exposures if and when rates deteriorate to unprofitable levels. As part of its long-term strategy, the Company also looks to its Life operations, Financial lines, and SCA segments to provide a diversified stream of earnings that are not directly tied to the property and casualty cycle.
The Company earns its revenue primarily from net premiums written and earned. In 2004 and 2005, pricing for most property and casualty lines of business experienced moderate declines as market conditions weakened following hard market conditions that had developed from 2000 through 2003. More specifically, in 2004, property and casualty market conditions overall remained attractive although price competition increased throughout the year, most notably in regards to property and professional lines. Accordingly, the Company continued to focus on disciplined risk selection. In 2005, downward pressure on rates across most non-catastrophe exposed lines continued throughout the year although the impact of the 2004 storm season, the backdrop of continued emergence of adverse development related to the market of the late 1990s and concerns about reinsurer financial strength, all served to reinforce a sense of discipline in the market.
Following the significant natural catastrophes of 2005, additional competitors were formed in the marketplace which had the effect of increasing the available capacity within the insurance and reinsurance markets. Although rates within some lines of business have experienced increases such as catastrophe exposed property lines of business, the entrance of these new competitors and an overall increasingly competitive environment, has had a dampening effect on rates within certain property and casualty lines of business, which ultimately has contributed to reducing gross and net premiums written in 2006.
During 2006, premium rates across most lines of business within the Insurance segment have generally been flat to down, however, the shortage of U.S. catastrophe capacity and resultant price movement has allowed growth in the Company’s catastrophe exposed property premiums during 2006 while it aggressively worked to reduce catastrophe exposures. The Company’s insurance property catastrophe reinsurance treaties renewed on July 1, with a material increase in reinsurance costs, driven not only by rate movements but an increase in limits purchased, although management expects less limits will be
In other lines of the Company’s Insurance segment, the Company has seen pricing in U.S. professional lines remain adequate across Directors’ and Officers’ (“D&O”), Design Professional and Select Professional lines of business. The Company’s recent entry into the private D&O market has shown significant growth. The Company views this market as an important future growth opportunity. While D&O pricing has been more aggressive in Europe, there have been reducing claim trends. In the environmental line, underwriting actions implemented in recent years are generating growth in new business production. In marine and offshore energy lines of business, despite risk management initiatives which have reduced our catastrophe exposures significantly, the Company has benefited from overall market price increases.
The Company also generates revenue from investment activities through returns on its investment portfolio. The Company’s current investment strategy seeks to support the liabilities arising from the operations of the Company, generate investment income and build book value over the longer term. During 2006, interest rates have increased in the U.S., U.K., and Euro-zone. The benchmark 90-day treasury rose from 4.08% to 5.02%, the 5-year treasury rose from 4.35% to 4.69%, and the 30-year treasury rose from 4.54% to 4.81%. Interest rates also increased in the U.K., where the yield on the benchmark 5-year Gilt rose from 4.17% to 5.06%, as well as in the Euro-zone, where the yield on the benchmark 5-year German Bund rose from 3.07% to 3.92%.
The following sets forth potential trends relevant to the Company’s general operations in 2007:
Initial indications in the Reinsurance segment show that while peak zone U.S. property capacity is still at a premium, competitive pressures are impacting most reinsurance lines. Notwithstanding this, generally the market continues to demonstrate underwriting discipline. During the January renewals, rate increases were noted for U.S. wind exposures of approximately 30% and increases of up to 20% for U.S. earthquake. Ocean marine pricing remains flat, unless it is wind exposed where price increases are expected. There has been some modest softening in US non-catastrophe exposed property pricing and in non-U.S. property pricing in general.
Casualty pricing trends in this segment are generally following those of the Insurance segment, with single digit price reductions, except for certain European casualty lines where there is some price improvement.
Return on average ordinary shareholder’s equity (“ROE”) is another financial measure that management considers important in evaluating the Company’s operating performance. ROE is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes minimum target ROEs for its total operations, segments and lines of business. If the Company’s minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit these lines. In addition, the Company’s compensation of its senior officers is significantly dependent on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE. In 2006, ROE was 19.6% due to solid underwriting results throughout its general and financial operations combined with investment and affiliate income. In 2005, the Company recorded a loss due to significant large catastrophe activity and losses related to the result of the Winterthur Decision.
In connection with the primary IPO of SCA shares, SCA issued 18,009,119 common shares at $20.50 per share for proceeds to SCA, net of offering costs, of approximately $342.2 million. In addition, upon completion of the secondary public offering of 5,430,774 shares previously held by the XL Insurance (Bermuda) Ltd, the Company received proceeds, net of offering costs, of approximately $104.7 million. The transaction resulted in a pre-tax reduction of the Company’s shareholders’ equity of $33.7 million, representing the difference between the carrying value of 100% of SCA immediately prior to the IPO and the sum of the secondary proceeds and the remaining carrying value of the Company’s ownership interest in SCA subsequent to the IPO, as well as, other costs and taxes incurred on the transaction. The portion of the reduction related to the primary offering of shares by SCA of $30.1 million was recorded as a direct reduction to shareholders’ equity, while the portion of the reduction related to the shares sold in the secondary offering of $3.6 million was included in realized gains (losses) in the accompanying statement of operations. In addition, the Company incurred income tax expenses of $6.0 million principally related to the transfer of XLCA to XL Insurance (Bermuda) Ltd, prior to the contribution of XLCA to SCA.
The Company’s ability to underwrite business is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company’s financial strength rating is downgraded, its ability to write business will be adversely affected. During the third and fourth quarters of 2005 a number of ratings actions were taken by independent rating agencies including some downgrades of the Company’s principal insurance and reinsurance subsidiaries. The Company subsequently raised $3.2 billion through an issuance of a combination of ordinary shares and equity security units. Strong underwriting results
and overall positive net income in 2006 has helped to maintain the Company’s ratings as noted in “Item 1 Business -Ratings” section above.
To address rating agency requirements regarding the differential between the triple-A ratings of the Company’s financial guaranty companies and their affiliated companies, the Company completed the IPO of SCA as described above. The formation of SCA has helped to provide greater independence and stability to XLCA’s and XLFA’s ratings. Thus, the financial strength ratings of XLCA and XLFA remain “triple A” with a stable outlook (by Standard & Poor’s, Moody’s and Fitch Ratings). For a further discussion see “Item 1 Business - Ratings” above.
Henry C.V. Keeling, formerly Global Head of Business Services and Chief Executive of Reinsurance Life Operations, was appointed Chief Operating Officer. Mr. Keeling assumes broad strategic responsibility for the Company’s underwriting risk assumption businesses, including insurance, reinsurance, life operations and financial lines. Clive Tobin, Chief Executive Officer Insurance, and Jamie Veghte, Chief Executive Officer Reinsurance Operations, continue in those roles, as members of the Company’s Executive Management Board and as the key leaders of the Company’s property and casualty segments, reporting to Mr. Keeling.
Michael C. Lobdell, a former Managing Director of New York-based JPMorganChase, joined the Company in September to serve as Chief Executive - Global Business Services. Mr. Lobdell is responsible for overall execution and service delivery across the entire Company and will oversee infrastructure and project management, including IT systems and technology, procurement, real estate, facilities, outsourcing and offshoring.
Additionally, during 2006 the Company announced the promotions of Sarah E. Street to the position of Chief Investment Officer, Kirstin Romann Gould to the newly-formed position of General Counsel of Corporate Affairs and Celia R. Brown to the position of Head of Global Human Resources.
At the segment executive management level, the Company also announced the appointment of Jamie Veghte to the position of Chief Executive of Reinsurance Operations, Robert Douglas to the position of Chief Executive of Life Operations and Daniel Sussman, to the position of Chief Executive of Financial Lines Operations. Messrs. Douglas, Veghte and Sussman report to the Company’s Chief Operating Officer, Mr. Keeling.
Susan E. Cross, formerly Chief Actuarial Officer of the Company’s reinsurance operations, was appointed Global Chief Actuary. In her new role, Ms. Cross will lead and oversee all major actuarial functions for the Company, including the establishment of unpaid losses and loss expenses, pricing benchmarks and related financial provisions.
In late 2006, Jerry de St. Paer, Chief Financial Officer, announced his decision to retire from the Company during 2007. Mr. de St. Paer will retire on March 5, 2007. The Company is in the process of an external search for a successor for Mr. de St. Paer. Ms. Luck will assume the role of interim CFO while the search is underway.
On June 7, 2006, subsidiaries of the Company, entered into an agreement (the “Agreement”) with WSIC, which the purpose of is to release all actual or potential disputes, claims or issues arising out of or related in any way to: (i) the Liquidity Facility and the Sellers Retrocession Agreements, as well as (ii) subject to certain exceptions, the SPA.
The Agreement replaces the protections provided to the Company from WSIC for reinsurance receivables and recoverables under the Liquidity Facility and Sellers Retrocession Agreements as described in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2005.
On October 18, 2006, the Company received approval to form a new European company, XL Re Europe Ltd, based in Dublin, Ireland, which is licensed to write all classes of reinsurance business. XL Re Europe Ltd is the headquarters of the Company’s European reinsurance platform and in 2006 it formed two new branches, one in the U.K. and one in France to facilitate the assumption of business previously underwritten by the U.K. branch of XL Re Ltd and XL Re Europe S.A. The non-life business of the U.K. branch of XL Re Ltd will be transferred into XL Re Europe Ltd on January 1, 2007 under Part VII of the Financial Services & Markets Act 2000. The business of XL Re Europe S.A. has been transferred to XL Re Europe Ltd under the “Transmission Universelle Du Patrimoine” (TUP) process.
In early 2006, the Company opened a representative office in Beijing, China. The opening of the office, which is permitted to act as a liaison point, conduct research and perform other non-income generating activities, demonstrates the Company’s commitment to the China market and the Company’s view of that market’s long-term potential in the areas of insurance and reinsurance.
A key strategic focus of the Company is the continued development and enrichment of its corporate culture and core values. The Company believes that a strong underlying corporate culture is a key factor in differentiating itself among its competitors. The Company’s corporate culture is defined by its five core values of ethics, teamwork, excellence, development, and respect. The Company believes that an appropriate tone from the top is a primary factor in the success of developing its corporate culture. As such, the Company holds regular town hall meetings where senior management review key decisions, strategy, and operating results with the staff and management who are then encouraged to address questions in an open format. To support its corporate culture, the Company also promotes a strong control environment through the continued development of its Framework for Internal Controls, its legal Compliance program, and internal control sub-certifications that support control certifications signed by senior management on a quarterly basis.
As a property and casualty insurer, the Company must ensure that it has sufficient funds to settle claims promptly, especially upon the occurrence of a major catastrophic event. Management is focused on making sure that liquidity requirements are supported by having lines of credit facilities available to the Company as well as by the Company’s general investment portfolio, the majority of which is invested in high grade fixed income securities. The Company has had significant positive cash flow from operations in the three years ended December 31, 2006 generated from its underwriting activities (premiums less claim and expense settlements) as well as the receipt of investment income on its portfolio. During 2005, capital raising activity provided significant cash flows from financing activities. The Company expects cash flow from operations to be positive in 2007.
The following table presents an analysis of the Company’s net income (loss) available to ordinary shareholders and other financial measures (described below) for the years ended December 31, 2006, 2005 and 2004:
Limited number of natural catastrophes during 2006 as compared to 2005 and 2004;
Other natural Catastrophes include European and Mumbai floods, Hurricanes Dennis, Emily and Ophelia and Typhoon Mawar.
During the two year period ended December 31, 2006, net reserves established for the events noted above have developed largely in line with expectations.
2. The impact of the unfavorable result of the Winterthur Decision
On December 6, 2005, the Company received the report from the Independent Actuary in connection with the Company’s post-closing protection for adverse development of net loss and unearned premium relating to the acquisition of certain Winterthur International insurance operations from WSIC in 2001.
approximately $575.0 million (including interest receivable) from WSIC. As the Company had recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, a loss of approximately $808.9 million, net of interest, was recorded in the fourth quarter of 2005.
The following table presents the net (favorable) adverse prior year loss development of the Company’s loss and loss expense reserves for its general and financial operations by operating segment for each of the years indicated:
During 2005, net prior year reserves across the Reinsurance segment developed adversely by $93.5 million. Reserve strengthening of $266.9 million in casualty and professional lines was partially offset by releases in other lines of business of $173.4 million. The casualty strengthening is primarily attributable to workers’ compensation, umbrella liability and certain professional lines of business written in the Company’s North American operations. The reserve releases relate primarily to the property line where releases of $135.6 million occurred across all business units globally in the 2002 to 2004 underwriting years. Releases also occurred in the marine and aviation classes of business across the Reinsurance segment.
During 2004, the Company’s net adverse prior year development of $268.0 million was a result of increases in reported insurance case reserves for excess professional liability, excess casualty liability and specialty lines within the Insurance segment offset by net prior year releases in the Reinsurance segment. These increases in reported insurance case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Strengthening of $144.0 million in professional lines was caused by a few large directors’ and officers’ claims in pre-2002 business, and increases in errors and omissions reserves were caused by claims related to large accounting firms and to insurance/reinsurance brokers. For specialty lines, strengthening of $135.0 million was caused by reported loss increases in discontinued programs business with workers’ compensation exposure, environmental related coverages, and Lloyd’s as well as high severity claims on the surety book.
itively to the year. Net income from both investment and operating affiliates was $380.7 million in 2006 compared to $222.3 million in 2005. This increase included a gain of $41.7 million on the sale of FrontPoint Partners LLC, an investment management affiliate, combined with good underlying alternative fund returns and strong results from certain private investment affiliates. See Item 8, Note 8 to the Consolidated Financial Statements, “Investments in Affiliates.”
As the Company earns premiums for the underwriting risks it assumes, it also establishes an estimate of the expected ultimate losses related to the premium. Loss reserves or unpaid losses and loss expenses are established due to the significant periods of time that may lapse between the occurrence, reporting and settlement of a loss. The process of establishing reserves for unpaid property and casualty claims can be complex and is subject to considerable variability, as it requires the use of informed estimates and judgments. These estimates and judgments are based on numerous factors, and may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Loss reserves include:
With respect to the Company’s insurance operations, the Company is notified of insured losses and records a case reserve for the estimated amount of the settlement, if any. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of legal counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. With respect to the Company’s reinsurance operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the estimated ultimate cost of a loss. The uncertainty in the reserving process for reinsurers is due, in part, to the time lags inherent in reporting from the original claimant to the primary insurer to the reinsurer. As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, the Company is subject to a potential additional time lag in the receipt of information as the primary insurer reports to the broker who in turn reports to the Company. As of December 31, 2006, the Company did not have any significant back-log related to our processing of assumed reinsurance information.
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, the Company believes that quantitative techniques to estimate these amounts are enhanced by professional and managerial judgment. Management reviews the IBNR estimates produced by the Company’s actuaries and determines its best estimate of the liabilities to record in the Company’s financial statements. The Company considers this single point estimate to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures.
When estimating IBNR reserves, each of the Company’s insurance and reinsurance business units segregate business into exposure classes (over 200 classes are reviewed in total). Within each class, the business is further segregated by either the year in which the contract incepted (“underwriting year”), the year in which the claim occurred (“accident year”), or the year in which the claim is reported (“report year”). The majority of the Insurance segment is reviewed on an accident year basis. The majority of the Reinsurance segment is reviewed on an underwriting year basis.
Over time, as a greater number of claims are reported, actuarial estimates of IBNR are based on the BF and loss development techniques. The BF method utilizes actual loss data and the expected patterns of loss emergence, combined with an initial expectation of ultimate losses to determine an estimate of ultimate losses. This method may be appropriate when there is limited actual loss data and a relatively less stable pattern of loss emergence. The chain ladder method utilizes actual loss and expected patterns of loss emergence to determine an estimate of ultimate losses that is independent of the initial expectation of ultimate losses. This method may be appropriate when there is a relatively stable pattern of loss emergence and a relatively larger number of reported claims. Multiple estimates of ultimate losses using a variety of actuarial methods are calculated for many, but not all, of the Company’s (200+) classes of business for each year of loss experience. The Company’s actuaries look at each class and determine the most appropriate point estimate based on the characteristics of the particular class and other relevant factors, such as historical ultimate loss ratios, the presence of individual large losses, and known occurrences that have not yet resulted in reported losses. Once the Company’s actuaries make their determination of the most appropriate point estimate for each class, this information is aggregated and presented to management for review and approval.
Discontinued asbestos and long-tail environment business had been previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to its acquisition by the Company. As at December 31, 2006, total gross unpaid losses and loss expenses in respect of this business represented less than 1% of unpaid losses and loss expenses.
Within the Insurance segment Other includes political risk, accident & health, surety, and other discontinued lines. Within the Reinsurance segment, Other includes political risk, surety, warranty, accident and health, and other lines.
Other specialty lines within the insurance segment includes environmental, programs, equine, warranty and excess and surplus lines.
The financial guaranties that the Company issues insure scheduled payments of principal and interest due on various types of financial obligations against payment default by the issuers of such obligations. Management establishes reserves for losses and loss adjustment expenses on such business based on management’s best estimate of the ultimate expected incurred losses. The Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including with respect to estimates regarding the occurrence and amount of a loss on an insured obligation. Estimates of losses may differ from actual results and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting insured obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor.
such as cash reserve accounts and letters of credit), as well as (to the extent applicable) other metrics indicative of the performance of such assets and the trends therein. Management’s ability to make a reasonable estimate of its expected loss depends upon its evaluation of the totality of both the available quantitative and qualitative evidence, and no one quantitative or qualitative factor is dispositive.
The Company updates estimates of losses and loss adjustment expense reserves quarterly and any resulting changes in reserves are recorded as a charge or credit to earnings in the period such estimates are changed. In connection therewith, the Company’s unallocated reserves are adjusted each period to reflect (i) revisions to management’s estimate of expected ultimate losses, if any, and (ii) the underlying par risk amortization of the related insured and reinsured in-force business (i.e., loss emergence pattern). As stated above, the Company’s estimated ultimate expected incurred losses are comprised of: (i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. As management establishes case basis reserves and pays claims it may, based on its judgment, reduce or increase the ultimate expected loss ratio used to determine unallocated reserves to reflect its best estimate of expected ultimate loss experience. In addition, under the Company’s accounting policy management may, based on its judgment, reduce unallocated reserves in response to significant case basis reserve and or paid loss activity. Management would only expect such reductions to occur in limited instances, such as economic events generating significant loss activity. Management has not viewed the Company’s case basis reserve and unallocated reserve activity to date to warrant a reduction of the Company’s unallocated reserves. In each quarterly period, there is an interplay between case basis reserves, unallocated reserves and cumulative paid losses to date, such that the aggregate thereof represents management’s best estimate of the ultimate losses it expects to incur on in-force business. The process of establishing unallocated reserves and periodically revising such reserves to reflect the underlying par risk amortization and management’s current best estimate of ultimate losses will ultimately cause the cumulative loss experience over the life of a particular underwriting year’s business to equal the cumulative inception-to-date actual paid losses on such business.
ratio, as management consider necessary, to ensure that such ratio continues to be appropriate for the risks inherent in the in-force business.
required by that review could have a material effect on the reported operating results and financial condition of the industry or particular market participants, including the Company, depending on the extent to which current policies differ from those promulgated by such regulatory bodies.”
The Company’s surveillance department is responsible for monitoring the performance of the in-force portfolio. They maintain a list of credits that they have determined need to be closely monitored and, for certain of those credits, they undertake remediation activities they determine to be appropriate in order to mitigate the likelihood and/or amount of any loss that the Company could incur with respect to such credits.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $5.7 billion and $5.2 billion at December 31, 2006 and 2005, respectively. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile. A 0.1% decrease in the investment yield assumption would result in a $52 million increase in the value of future claims related to annuity portfolio reinsurance.
As stated above, the future policy benefit reserves include provisions for adverse deviation in excess of best estimate assumptions that amounted to approximately $371 million and $310 million at December 31, 2006 and 2005, respectively. The future policy benefit reserves would only be increased if these provisions for adverse deviation became insufficient in the light of emerging claims experience. The present value of future claims would increase by approximately $20 million if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions.
The Company also provides reinsurance of disability income protection, for an in-force block of business. The future policy benefit reserves for these contracts amounted to $79 million and $85 million at December 31, 2006 and 2005, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience. The 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 $0.7 million, while a 1% decrease in the termination rate would increase the value of future claims by approximately $0.7 million. No changes to the locked-in assumptions have been made in 2006, although changes were made in 2005 which resulted in the removal of the provisions for adverse deviation.
The Company also provides reinsurance of term assurance and critical illness policies written in the U.K. and Ireland. The future policy benefit reserves for these contracts amounted to $135 million and $62 million at December 31, 2006 and 2005, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience. The provisions for adverse deviation in these reserves amounted to $12 million and $5 million at December 31, 2006 and 2005, respectively.
The Company’s deposit liabilities at December 31, 2006 reflect obligations assumed under funding agreements, municipal guaranteed reinvestment contracts, payment undertaking agreements and certain structured insurance and reinsurance agreements. For each of these contracts, the Company establishes a deposit liability equal to the net cash received at inception. Each deposit liability accrues at a rate equal to the internal rate of return of the payment receipts and obligations due during the life of the agreement. Where the timing and/or amount of future payments are uncertain, cash flows reflecting the Company’s actuarially determined best estimates are utilized. The ultimate size of underlying losses, the impact of the contractual limits upon settlement of such losses, and the impact of the underlying loss settlement process on the timing of payments are considered as appropriate. Where uncertainty is present, an increase in the ultimate claims cost or accelerated claims settlement would potentially lead to an increase in the deposit liability accretion rate or lead to incurred losses if significant. The interest expense reported due to the accretion of deposit liabilities associated with structured insurance and reinsurance contracts was $37.8 million, $49.8 million and $59.4 million for
the years ended December 31, 2006, 2005 and 2004, respectively. For some of the Company’s deposit liabilities, the accretion rate is recorded at its contractual maximum level. For all other contracts, a 1% increase in the average accretion rate would result in an increase in deposit liabilities and interest expense by $19.2 million on an annualized basis. See Item 8, Note 12 to the Consolidated Financial Statements, “Deposit Liabilities.”
The Company enters into credit derivatives in connection with its financial guaranty business and the Company intends to hold these contracts to maturity. In determining fair value, management differentiates between investment and non-investment grade exposures and models them separately. Management estimates fair value for investment grade exposures by monitoring changes in credit quality and selecting appropriate market indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value. For credit derivatives that are non-investment grade and therefore do not have a readily determinable market value, the Company uses an alternative fair value methodology. The fair value is determined using a cash flow model developed by the Company and is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. Installment premiums are also considered in the determination of discounted net cash flows. Other elements of the change in fair value are based upon pricing established at the inception of the contract. Changes in fair value are unrealized as the credit derivatives are not traded to realize this value. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis and Item 8, Note 15 to the Consolidated Financial Statements, “Derivative Instruments.”
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These primary factors include (i) the time period during which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question, (v) expected future interest rate movements, and (vi) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized in the period such determination is made.
The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company has capitalized net operating tax losses of $334.0 million and $238.1 million against which a valuation allowance of $198.9 million and $130.8 million at December 31, 2006 and 2005, respectively, was established. The Company has capitalized realized and unrealized capital losses of $11.3 million and $8.4 million, respectively, against which a valuation allowance of $19.7 million at December 31, 2006 was established. The deferral of benefits from tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts, the character of income and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax affected.
For further information see “- Other Revenues and Expenses” and Item 8, Note 25 to the Consolidated Financial Statements, “Taxation.”
The Company evaluates the performance of each segment based on underwriting results for general operations, and contribution from both life and financial operations. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate assets by segment for its general operations. Investment assets related to the Company’s life and financial operations are held in separately identified portfolios. Net investment income from these assets is included in net income from life operations and contribution from financial operations, respectively.
The Company’s business is conducted on a global basis where several of its subsidiaries operate in foreign currencies which are the base currency of that entity. Under U.S. GAAP, revenues and expenses of those operations are translated into the U.S. dollar at average exchange rates during the year and assets and liabilities at exchange rates at the end of the year.
Net premiums earned decreased marginally by 0.1% in the year ended December 31, 2006 compared with the year ended December 31, 2005. The decrease over the prior year was primarily attributable to the reasons noted above
Fee income and other decreased in 2005 compared to 2004 primarily due to the income recorded on the sale of property in London in 2004, combined with fees generated by the Company’s professional lines start up businesses for administration of third party portfolios.
The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss and loss reserves held at the beginning of the year.
The underwriting expense ratio in the year ended December 31, 2006 increased compared to the same period in 2005, as a result of an increase in the operating expense ratio of 3.0 points (15.6 % as compared to 12.6%) partially offset by a lower acquisition expense ratio. The increase in the operating expense ratio was due primarily to increased performance-based compensation costs. The lower acquisition expense ratio related primarily to a reduction in certain ceded brokerage costs in 2006 combined with the impact on the expense ratio of reinstatement premiums earned in 2005.
Within the Reinsurance segment, the decrease in the loss and loss expense ratio in the year ended December 31, 2006, compared to the same period in 2005, primarily reflected the lack of large natural catastrophe events such as those that occurred during 2005. Excluding these events, the loss ratio for 2005 was 65.3%. The relative decrease in 2006 is largely due to favorable prior year reserve development. During the year ended December 31, 2006, net overall favorable prior year reserve development for the year ended 2006 was $125.7 million. This overall favorable development was made up of releases of $190.2 million in property and other shorter-tail lines of business and $10.9 million in casualty lines, partially offset by $75.4 million in adverse development specifically related to the 2005 catastrophes. Net releases in casualty lines reflect positive claims experience in the core U.S. reinsurance and primary books including those years subject to the CAR review in 2003 partially offset by some older asbestos and environmental development and $18.0 million related to a disputed claim impacting underwriting years 1996-2000 that settled during the year. The gross prior year favorable development for the Reinsurance segment was $46.0 million. This gross favorable development was less than the corresponding net development as net strengthening on the 2005 catastrophes was less significant than the gross strengthening due to reinsurance recoveries.
The increase in the loss and loss expense ratio in the year ended December 31, 2005, compared to the same period in 2004, primarily reflected the effects of Hurricanes Katrina, Rita and Wilma combined with the Other Cats from which the Reinsurance segment incurred a combined $977.9 million of net losses. As noted above these natural catastrophes added 34.4% to the segment loss ratio for the year ended December 31, 2005.
Exchange gains in the year ended December 31, 2006 were mainly attributable to an overall weakening in the value of the U.S. dollar against the U.K. Sterling in those operations with U.S. dollars as their functional currency and net U.K. Sterling assets. Exchange losses in the year ended December 31, 2005 were mainly attributable to an overall strengthening in the value of the U.S. dollar against U.K. Sterling and the Euro.
With respect to the Life operations, gross and net premiums written, net premiums earned and claims and policy benefits in each of the three years ended December 31, 2006, 2005 and 2004 included the assumption of the following long duration annuity portfolios:
2. Second and fourth quarters of 2005 - A large U.K. immediate annuity portfolio contract bound representing $1.8 billion in net premiums earned and two Irish immediate annuity portfolios which totalled $96.2 million.
3. Second and fourth quarters of 2004 - Two large U.K. and Irish portfolio contracts, representing $995 million in net premiums earned and related claims and policy benefits.
The Company acquired cash and investment assets related to the future policy benefit reserves assumed at inception of these large contracts. While the Company expects to write more of these contracts, the frequency of these transactions will likely continue to be irregular and their sizes will differ from transaction to transaction.
Excluding these large contracts, net premiums earned in life operations increased in 2006 compared with 2005 and 2005 compared with 2004, as the Company expanded its life and annuity reinsurance operations in Europe, and has continued to bind additional regular premium term assurance contracts which generate ongoing premiums.
Acquisition costs decreased in 2006 as compared to 2005 due to the write-off of certain deferred costs of $25.9 million related to the U.S. mortality business noted above during the prior year, and partially offset by increased acquisition expenses on higher volume of installment premium term assurance business. Operating expenses increased in 2006 as compared to 2005 due to build out of existing operations and start-up costs of new life operations including the U.S. life reinsurance platform and the U.K. life fund integration team, as well as an increase in professional fees related to these initiatives.
Increases in gross and net premiums written of 33.0% and 29.5%, respectively, in 2005, as compared to 2004, were primarily due to additional premiums due in 2005 on a structured property and casualty policy, which incurred a loss related to Hurricane Katrina, as well as premiums from several new structured property and casualty policies written during the year. Financial guaranty premiums remained relatively flat in 2005, as compared to 2004.
The increase in net premiums earned of 42.8% during 2005, as compared to 2004, primarily resulted from additional premiums due in 2005 on a structured property and casualty policy which incurred a loss related to Hurricane Katrina, as well as new structured property and casualty business production in 2005, offset in part by lower earned premium in the financial guaranty line of business in 2005, as compared to 2004.
For the year ended December 31, 2006, acquisition costs decreased by 2.7% as a result of slightly lower average broker costs associated with earned premium. For 2005, acquisition costs increased by 4.7% as compared to 2004. This increase consisted of slightly higher acquisition expenses in the guaranteed investment contract and funding agreement businesses.
Net income from financial and investment affiliates include earnings on the Company’s investment in Primus and certain of the Company’s investment affiliates. Primus specializes in providing credit risk protection through credit derivatives. The increase in the year ended December 31, 2006 as compared to the same period in 2005 was due primarily to the profitability of Primus which contributed $22.6 million in 2006 as compared with $4.6 million in 2005, combined with continued strong performance of certain investment affiliates. The decrease in such earnings in 2005, as compared to 2004, was due primarily to the lower earnings from Primus in 2005.
atives. The net gains from derivatives for the year ended December 31, 2006 included realized gains from certain weather derivative contracts for the 2005/2006 winter, positive mark to market adjustments on certain credit default swap risks, and partially offset by negative movements in certain investment grade credit derivative exposures and the amortization of prior mark-to-market gains.
Net realized and unrealized gains on derivative instruments increased 35.7% in 2005, as compared to 2004. Results in 2005 were driven largely by an $18.6 million gain on the settlement of a structured market risk management derivative product tied to a housing price index, and $17.8 million net realized and unrealized gains in the weather and energy business. Results in 2004 primarily consisted of unrealized gains on certain credit derivatives.
The following table summarizes the net contribution and net income for SCA segment:
Financial guaranty up-front premiums are earned over the life of the insured debt obligations based on par amount of risk outstanding. Financial guaranty installment premiums are earned over the installment period.
Gross and net premiums written relating to the financial guaranty line of business reflect premiums received and accrued for in the periods presented and do not include the present value of future cash receipts expected from financial guaranty installment premium policies and contracts written in the period. Gross and net premiums written increased by 45.6% and 52.6%, respectively, in the year ended December 31, 2006 as compared to the same period in 2005. These increases were primarily as a result of an increase in the volume and mix of financial guaranty upfront contracts written throughout this time period. Net premiums written also increased as a result of the inter-segment portfolio transfer of in-force financial guaranty contracts with the Financial lines segment and the early retirement of certain guaranteed obligations.
Gross premiums written increased by 3.1% in 2005 as compared to 2004. A decline in up-front premiums written was offset by an increase in installment premiums written. Upfront premiums declined due to tighter credit
spreads and increased market competition across our business lines. The increase in installment premiums reflected the growth of the in-force book of installment business.
The increase in net premiums earned in 2006, as compared to 2005, was primarily due to the growth of the in-force business (in particular, installment premium business written in prior periods) and earned premiums from the early retirement or refunding of insured securities of $27.4 million, as compared to $14.8 million in 2005.
Acquisition costs increased by 12.0% for the year ended December 31, 2006, as compared to the same period in 2005. The increase primarily reflects the impact of refundings noted above combined with higher direct and indirect acquisition costs resulting from the growth of in-force business. Acquisition costs decreased by 5.7% for the year ended December 31, 2005, as compared to the same period in 2004. This decrease was primarily due to a change in business mix to more installment-based policies, resulting in lower deferred costs associated with premium and excise taxes.
Net investment income increased by 50.1% in the year ended December 31, 2006, as compared to the same period in 2005, primarily as a result of increases in the investment asset balances in 2006, proceeds received from the IPO in August 2006, together with increased yields.
Refer to “Investment Activities” below for an analysis of net realized and unrealized losses on investments and investment derivatives.
Net investment income related to general operations increased in 2006 as compared to 2005 due primarily to increases in the yield of the portfolio and a higher investment base. The market yield to maturity on the fixed income portfolio was 5.2% at December 31, 2006, as compared to 4.7% at December 31, 2005, due primarily to higher interest rates in the U.S., U.K., and Euro-zone. The growth in the investment base reflected the Company’s issuance of ordinary shares and equity units in the fourth quarter of 2005 and the Company’s positive cash flow from operations.
It is expected that net investment income in 2007 will increase due to projected increases in investments resulting from an increase in the average investment base, as well as anticipated increases in portfolio yields on reinvestment of existing assets and investment of new cash flows. However, actual market changes in interest rates could offset or supplement the effects of cash flow. For a further discussion see “Liquidity and Capital Resources.”
The Company manages its investment grade fixed income securities using an asset/liability management framework. Due to the unique nature of the underlying liabilities, customized benchmarks are used to measure investment performance and comparison to standard market indices is not meaningful. Investment performance is not monitored for certain assets primarily consisting of operating cash and special regulatory deposits. The following is a summary of the investment portfolio returns for the years ended December 31, 2006 and 2005 of the asset/liability portfolio and risk asset portfolios:
In 2005, net realized gains on investments were $241.9 million which includes $250.8 million of gross realized losses on fixed income and $54.1 million of gross realized losses on equity securities. Gross realized losses in 2005 included $53.2 million of provisions for declines in fair value considered to be other than temporary.
With respect to those investment securities that were sold at a loss during the year ended December 31, 2005, the following is an analysis of the period of time that those securities had been in a continual unrealized loss position, the amount of the realized loss recorded in the Company’s results of operations as of the sale date and the amount of the impairment charge taken in the year:
During the year ended December 31, 2006, the Company realized losses of $7.6 million and $1.2 million upon the sale of fixed income securities and equity securities, respectively, that had been in an unrealized loss position for greater than twelve months. During the year ended December 31, 2005, the Company realized losses of $32.2 million and $2.1 million upon the sale of fixed income securities and equity securities, respectively, that had been in an unrealized loss position for greater than twelve months. The decisions to sell these securities were made by the Company’s investment managers based upon a change in market conditions and other factors (these decisions were independent of the Company’s previously stated intent and ability to hold such securities).
At December 31, 2006, the Company had net (pre-tax) unrealized gains on fixed income and short-term securities of $139.8 million and net unrealized gains on equity securities of $185.6 million. Of these amounts, gross unrealized losses on fixed income and short-term securities and equities were $244.1 million and $5.4 million, respectively. At December 31, 2005, the Company had net unrealized gains on fixed income and short-term securities of $319.0 million and net unrealized gains on equity securities of $171.9 million. Of these amounts, gross unrealized losses on
fixed income and short-term securities and equities were $312.7 million and $8.8 million, respectively. These losses include securities below investment grade, as discussed below.
The following is an analysis of how long each of those investment securities with an unrealized loss at December 31, 2006 and 2005 had been in a continual unrealized loss position:
At December 31, 2006, the total gross unrealized losses represented approximately 9,700 fixed income securities out of a total of approximately 17,300 and approximately 200 equity securities out of a total of approximately 1,300. At December 31, 2005, the total gross unrealized losses represented approximately 9,100 fixed income securities out of a total of approximately 17,300, and approximately 400 equity securities out of a total of approximately 1,800.
Of the gross unrealized investment losses on the fixed income and short term investments portfolio at December 31, 2006 of $244.1 million, approximately $122.5 million related to corporate fixed income securities. Within the cor-
Of the $312.7 million gross unrealized investment losses on the fixed income and short term investments portfolio at December 31, 2005, approximately $118.8 million related to corporate fixed income securities. Within the corporate fixed income securities, approximately 55.3% of the losses were in the financial sector, 9.8% in the communications sector, 9.4% in the consumer, non-cyclical sector and 5.6% in the consumer cyclical sector. No other sector was greater than 5%. The largest individual unrealized loss in the fixed income portfolio was $5.0 million. No equity securities held by the Company at December 31, 2005, were in a continual unrealized loss position for at least 12 months. The largest individual unrealized loss in the equity portfolio was $0.3 million.
At December 31, 2006 and 2005, the following table sets forth the maturity profile of the fixed income securities that were in a gross unrealized loss position:
Income tax expense does not include SCA’s income tax charge (benefit).
In 2006, the increase in net income from operating affiliates was primarily due to the gain on sale of the FrontPoint Partners LLC, an investment mangement affiliate, of $41.7 million. The results also include continued strong performance by the Company’s investment management affiliates driven by strong growth in assets managed by these minority-owned managers.
In 2004, net income from operating affiliates included strong performance by the Company’s investment management affiliates combined with income of $66.7 million on the sale of the Company’s investment in the Admiral Group Ltd. and $35.4 million of income from the sale of the Company’s stake in Pareto Partners L.P. and its affiliated companies, as well as strong growth in assets managed by these minority-owned managers.
Amortization of intangible assets decreased in 2006 as a result of certain intangible assets that were fully amortized during the year.
Corporate operating expenses in 2006 increased by 4.7% primarily as a result of increased performance-based compensation costs and increased legal costs.
The change in the Company’s income taxes in each of the three years ended December 31, 2006, 2005 and 2004 principally reflects the effects of changes in the profitability of the U.S. and European operations for each year. Income tax expense for the year ended December 31, 2006 increased from 2005 principally from an improvement in the profitability of the Company’s U.S. and European operations. The Company’s effective tax rate for the year ended December 31, 2006 decreased slightly from that in 2005 due to $30.0 million of tax benefits associated with corrections in the year to reserves ceded to its Bermuda reinsurance entities. In addition, the Company recorded a tax charge in 2006 of $6.0 million in connection with the IPO of SCA. Income tax expense for the year ended December 31, 2005 decreased from 2004, due primarily to losses incurred in the Company’s U.S. operations as a result of the 2005 catastrophe activity. A significant proportion of the loss reserve increases were captured in non-U.S. subsidiaries where no tax relief is available.
The deferral of tax losses is evaluated based upon the future profitability of the Company’s taxable entities and, under current projections, the Company anticipates using this asset. The Company’s net deferred tax asset at December 31, 2006 was $346.1 million, which consists primarily of net operating losses generated by subsidiaries in the U.S. and U.K. Should the taxable income of these entities fall below expectations, a further valuation allowance may 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 effected. See “Critical Accounting Policies and Estimates” and Item 8, Note 25 to the Consolidated Financial Statements, “Taxation.”
The primary objectives of the investment strategy are to support the liabilities arising from the operations of the Company, generate stable investment income and to build book value for the Company over the longer term. The strategy strives to maximize investment returns while taking into account market and credit risk. The Company’s overall investment portfolio is structured to take into account a number of variables including local regulatory requirements, business needs, collateral management and risk tolerance.
At December 31, 2006 and 2005, total investments, cash and cash equivalents, and net payable for investments purchased were $44.3 billion and $41.2 billion, respectively. The following table summarizes the composition of the Company’s invested assets at December 31, 2006 and 2005:
While the Company reviews the adequacy of established reserves for unpaid losses and loss expenses regularly, no assurance can be given that actual claims made and payments related thereto will not be in excess of the amounts
The Company has credit risk should any of its reinsurers be unable or unwilling to settle amounts due. Of the $6.1 billion total unpaid losses and loss expenses recoverable and reinsurance balances receivable at December 31, 2006, no individual reinsurer accounted for 10% or more of the total. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $2.2 billion at December 31, 2006, collateralizing reinsurance recoverables with respect to certain reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify the Company primarily because of disputes under reinsurance contracts and insolvencies. As at December 31, 2006 and 2005, the Company had a reserve for potential non-recoveries from reinsurers of $218.3 million and $260.7 million, respectively.
Under the terms of the Sale and Purchase Agreement (the “SPA”), as amended, between XL Insurance (Bermuda) Ltd (“XLI”) and Winterthur Swiss Insurance Company (“WSIC”), WSIC provided the Company with post-closing protection determined as of September 30, 2004 with respect to, among other things, adverse development of reserves and premium on certain Winterthur International Insurance business. This protection was based upon net loss experience and development over a three-year, post-closing seasoning period based on actual loss development experience, collectible reinsurance and certain other factors set forth in the SPA. The SPA included a process for determining the amount due from WSIC by an independent actuarial process whereby the Independent Actuary developed a value of the seasoned net reserves. The actual final seasoned net reserves amount was the submission that was closest to the number developed by the Independent Actuary.
For financial statement purposes, at each reporting period end subsequent to the SNRA and NPRA submissions being made in February of 2005, the Company assessed the two possible outcomes regarding the SNRA and after considering any new or changed information arising from the process, determined whether it continued to be probable that the Company’s SNRA would become the final SNRA as a result of the Independent Actuarial process. If at any time during the process management had concluded, based on the then current information, that the Independent Actuary would calculate an SNRA closer to WSIC’s SNRA submission, then a loss amounting to the entire difference between the two values would have been recorded. Management did not conclude that this was appropriate at any time prior to the receipt of the Independent Actuary’s draft report on November 23, 2005. Specifically, during the third quarter of 2005, further detailed internal analysis was conducted by management to re-evaluate the probability that the Company would be successful in the Independent Actuarial process. All areas where there was a potential that WSIC’s SNRA submission may have been accepted over the Company’s were examined, effectively estimating a reasonable worst-case scenario outcome from the Company’s point of view. This was compared to the midpoint of the difference between the two submissions. Management continued to believe the Company would be successful in the process.
There were many individual differences between the Independent Actuary’s calculation of the SNRA and that of the Company attributable to different judgment calls, different actuarial methodologies and sources of data. These related primarily to the following five areas:
The Independent Actuary selected projection methodologies different than the Company’s. Most significantly the Independent Actuary’s weighting of paid loss projection versus incurred loss projection was different from the Company’s which gave rise to differing conclusions regarding future loss development. The Company continues to believe that its methodology, which was adopted by in-house actuaries and reviewed by both outside actuaries and included in the financial statements audited by the Company’s outside auditors, is appropriate and has not changed its loss projections based on the Independent Actuary’s report. The methodology used by the Company’s actuaries for these reserves is consistent with that used by the Company’s actuaries for similar risks written in other business units of the Company.
The Independent Actuary made different assumptions than the Company regarding the classification of data used in the actuarial analysis. For example, the Independent Actuary characterized losses as large losses for purposes of separate treatment in his actuarial analysis at a level that was different from the Company. The Company’s loss reserves and actuarial methodologies were reviewed both internally and externally by outside actuaries and included in the financial statements audited by the Company’s outside auditors.
The losses resulting from the determinations of the Independent Actuary were recorded in the fourth quarter of 2005 as it was at this time that the draft and final reports of the Independent Actuary were released and sufficient new information was available to support recording a loss for uncollectible reinsurance based on the baseball-type arbitration which allowed for only one of two outcomes. At no time before the release of that report did the Company believe that recognition of a loss under FAS 5 was appropriate.
Item 8, Note 26 to the Consolidated Financial Statements, “Statutory Financial Data”, for further discussion. No assurance can be given that the Company or its subsidiaries will be permitted to pay dividends in the future.
The receipt of investment income on the Company’s total investment portfolio; and
The net receipt of premiums less claims and expenses related to its underwriting activities in general, life, and financial operations.
31, 2006, could be as long as a thirty year period. Property claims are generally reported and settled within a much shorter period, usually up to three years.
If paid losses accelerated beyond our ability to fund such paid losses from current operating cash flows, the Company might need to either liquidate a portion of our investment portfolio or arrange for financing. To further ensure the sufficiency of funds to settle such claims, the Company holds a certain amount of invested assets in cash and short-term investments and maintains available credit facilities. In addition, for certain insurance, reinsurance, or deposit contracts that tend to have relatively large and reasonably predictable cash outflows, the Company attempts to establish dedicated portfolios of assets that are duration-matched with the related liabilities.
In May 2007, purchase contracts associated with the Company’s 6.5% equity security units mature and the related 2.53% senior notes will be remarketed and the interest rate reset. Management continues to review the impact and on-going implications of this liquidity event and more broadly the efficiency of the Company’s capital structure.
The Company is considered a Well Known Seasoned Issuer (“WKSI”) under the rules of the SEC. The Company maintains shelf registration statement and is eligible for automatically effective future registration statements for the potential offering and sale of an unlimited amount of debt and equity securities. The Registration Statement allows for the following types of securities to be offered: (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, (ii) preferred securities of any of one or more capital trusts organized by the Company and guarantees of such securities by the Company and (iii) debt securities of XL Capital Finance (Europe) plc and guarantees of such securities by the Company.
The Company’s principal credit facilities are multi-year transactions with maturities in 2008 and 2011, however, the Company has other credit facilities that will expire in 2007. The following risks are associated with the Company’s requirement to renew these facilities during 2007:
The volume of business that the Company’s non-admitted subsidiaries are able to transact could be reduced if the Company is unable to renew its letter of credit facilities at an appropriate amount.
In December 2005, the Company issued 38.9 million ordinary shares at a price of $65.0 per share to support capital requirements subsequent to the 2005 Atlantic hurricane losses and the loss related to the conclusion of the Winterthur Decision. The net proceeds from this issuance were $2.4 billion. See Item 8, Note 21, to the Consolidated Financial Statements, “Share Capital.”
Revolving credit facilities of $1.45 billion in aggregate. These facilities were unutilized at December 31, 2006. In January 2006, the Company repaid $45 million that had been outstanding at December 31, 2005. The revolving credit facilities were not otherwise utilized during 2006. Of the $1.45 billion, $1.0 billion is provided by the Company’s $2.0 billion 3-year syndicated facility that matures in June 2007, and its $2.35 billion 5-year syndicated facility that matures in June 2010. Both facilities provide letters of credit in addition to the revolving credit sublimit. In addition, at December 31, 2006, the Company had two bilateral revolving credit facilities of $100 million each, of which one facility is a 364-day facility that matures in December 2007, and the other is a 5-year facility that matures in August 2007. SCA has a $250 million revolving credit facility that was unutilized during 2006 and at December 31, 2006.
“Commitment” and “In Use” data represent December 31, 2006 accreted values. “Payments Due by Period” data represent ultimate redemption values.
Series A Preferred In August 2002, the Company issued 9.2 million of 8% Series A preference ordinary shares (“Series A preference shares”). Gross proceeds were $230.0 million and related expenses were $7.2 million. Upon dissolution of the Company, the holders of the Series A preference shares are entitled to receive a liquidation preference of $25 per share, plus accrued dividends. Dividends on the preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Series A preference shares on or after August 14, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the Series A preference shares before August 14, 2007 at specified redemption prices, plus accrued dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Series A preferred shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Series A preference shares ($25 per share redemption price). The proceeds were used for general corporate purposes.
Series B Preferred In November 2002, the Company issued 11.5 million of 7 5/8% Series B preference ordinary shares (“Series B preference shares”). Gross proceeds were $287.5 million and related expenses were $9.1 million. Upon dissolution of the Company, the holders of the Series B preference shares are entitled to receive a liquidation preference of $25 per share, plus accrued dividends. Dividends on the preference shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Series B preference ordinary shares on or after November 18, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the B preference shares before November 18, 2007 at specified redemption prices, plus accrued dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Series B preferred shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Series B preference shares ($25 per share redemption price). The proceeds were used for general corporate purposes.
In addition to funded debt transactions, the Company and a majority-owned subsidiary of SCA (XL Financial Assurance Ltd. (“XLFA”)) have entered into contingent capital transactions. No up-front proceeds were received by the Company or XLFA under these transactions, however, in the event that the associated irrevocable put option agreements are exercised, proceeds previously raised from investors from the issuance of pass-through trust securities would be received in return for the issuance of preferred shares.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company. In connection with this transaction, the fair value of the put premiums and other related costs, in total of $111.9 million was transferred from “Additional paid in capital” to a deferred liability which was established (included with “Other liabilities”) in the consolidated balance sheet at December 31, 2003.
At December 31, 2006, the Company had ten letter of credit facilities in place with total availability of $6.4 billion, of which $3.8 billion was utilized.
The Company closed a new $500 million syndicated credit facility on May 9, 2006. The new facility has a tenor of 364-days and is available for letters of credit only.
SCA closed a new $500 million syndicated letter of credit facility on August 1, 2006. The new facility has a tenor of 5-years and is only available for SCA and its subsidiaries. This facility has $250 million available in the form of revolving credit and the remaining $250 million is available for letters of credit.
The Company replaced a $150 million letter of credit facility that matured in December 2006 with a new facility of the same amount. The new facility has a tenor of 364-days and closed on December 19, 2006.
The Company replaced a $100 million credit facility that matured in December 2006 with a new facility of the same amount. The new facility has a tenor of 364-days and closed on December 16, 2006.
$500 million commercial paper-based facility. In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”). These facilities were increased to $500.0 million in June 2003. The proceeds of advances under the Credit Facilities were used to fund a trust account to collateralize the reinsurance obligations of the Company under an inter-company quota share reinsurance agreement. The Company could face additional obligations under the Credit Facilities prior to the stated maturity of February 25, 2008, if certain events were to occur, including, but not limited to the Company’s insolvency, withdrawal of assets from the Regulation 114 trust by the ceding company, the downgrade of the Company’s credit ratings below certain specified levels, or the failure of the agent to have a first priority perfected security interest in the collateral posted by the Company. At maturity, the Company will be obligated to make payments in an amount equal to the principal and accrued interest outstanding under the Credit Facilities. The issued securities and the Company’s repayment obligations are recorded as a net balance on the Company’s balance sheet.
Under the Company’s 364-day facilities, 3-year credit facility, five-year credit facilities placement notes described above, in the event that the XL Capital Group, XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur. The Company currently has an “A+ (stable)” rating from A.M. Best.
The following table presents the Company’s long term contractual obligations and related payments as at December 31, 2006, due by period. This table excludes further commitments of $177.8 million to the Company’s related investment funds, certain limited partnerships, insurance affiliates, collateralized debt/equity investments and letter of credit facilities of $3.8 billion. See Item 8, Note 15, “Derivative Instruments”, and Note 19, “Commitments and Contingencies”, to the Consolidated Financial Statements. See Item 8, Note 14, “Notes Payable and Debt and Financing Arrangements”, to the Consolidated Financial Statements for further information.
The unpaid loss and loss expenses were $23,080,142 on the Company’s Consolidated Balance Sheet at December 31, 2006. The timing and amounts of actual claims payments related to these reserves vary based on many factors including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claims payments could differ materially from the Company’s estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors effecting potential payment patterns of reserves for actual and potential claims related the Company’s different lines of business see “Critical Accounting Policies and Estimates” above. Certain lines of business written by the Company, such as excess casualty, have loss experience characterized as low frequency and high severity. This may result in significant variability in loss payment patterns and, therefore, may impact the related asset/liability investment management process. In order to be in a position, if necessary, to make these payments, the Company’s liquidity requirements are supported by having revolving lines of credit facilities available to the Company and significant reinsurance programs, in addition to the Company’s general high grade fixed income investment portfolio.
Future policy benefit reserves related to Life operations were $6,290,936 on the Company’s Consolidated Balance Sheet at December 31, 2006. Amounts included 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 the Company’s estimated amounts.
Contingent capital facilities related payments include an estimate at the payments due under the past option agreement of $200 per month. Actual payments depend on the return on certain assets and LIBOR.
The Company utilizes variable interest entities both indirectly and directly in the ordinary course of the Company’s business.
In December 2004, XLFA entered into a put option agreement and an asset trust expense reimbursement agreement with the Asset Trust. The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase XLFA’s non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. XLFA is obligated to reimburse the Asset Trust for certain
fees and ordinary expenses. To the extent that any Series B Preferred Shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the asset trust expense reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 9, 2009, or under certain defined circumstances, such as the failure of XLFA to pay the put option premium when due or bankruptcy. The put option is recorded at fair value with changes in fair value recognized in earnings.
Consolidated Statements of Income and Comprehensive Income for the years ended
FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004 (Continued)
XL Capital Ltd, through its operating subsidiaries (the “Company” or “XL”), is a leading provider of insurance and reinsurance coverages, and financial products to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis. The Company and its various subsidiaries operate globally in 28 countries, through its five business segments: Reinsurance, Insurance, Life operations, Financial lines, and Security Capital Assurance (“SCA”). These segments are further discussed in Note 4 to the Consolidated Financial Statements, “Segment Information.”
These consolidated financial statements include the accounts of the Company and all of its subsidiaries. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated. Certain amounts in 2005, 2004, and 2003 have been reclassified to conform to the current year presentation.
On August 4, 2006, the Company completed the sale of approximately 37% of its financial guaranty insurance and reinsurance businesses (the “Transferred Business”) through an initial public offering (“IPO”) of 23.4 million common shares of SCA at $20.50 per share. SCA was incorporated in Bermuda in March 2006 for the sole purpose of becoming the parent company for the Transferred Business. Subsequent to the completion of the IPO, the Company owns 63% of the outstanding common shares of SCA, although there are certain limitations on the Company’s voting rights. From an accounting perspective, these limitations did not result in a loss of control and as such, the Company continues to consolidate SCA based upon the aggregate impact of its retained controlling interest. For further information see Note 3 to the Consolidated Financial Statements, “Sale of Financial Guaranty Business.”
Premiums are earned on a pro-rata basis over the period the coverage is provided. Financial guaranty insurance premiums are earned pro-rata to the amount of risk outstanding over the life of the exposure. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force. Net premiums earned are presented after deductions for reinsurance ceded, as applicable.
Reinstatement premiums are recognized and earned at the time a loss event occurs.
Acquisition costs, which vary with and are directly related to the acquisition of policies, consist primarily of commissions paid to brokers and cedants and certain underwriting costs and are deferred and amortized over the period that the premiums are earned. Acquisition costs are shown net of commissions earned on reinsurance ceded. Future earned premiums, the anticipated losses and other costs (and in the case of a premium deficiency, investment income) related to those premiums, are also considered in determining the level of acquisition costs to be deferred.
The Company conducts its derivative activities in three main areas: credit derivatives, weather and energy derivatives and investment related derivatives.
Credit derivatives are recorded at fair value, which is determined using either models developed by the Company or third party prices and is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. 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.
Fair values for the Company’s natural gas contracts are determined through the use of quoted market prices. As quoted market prices are not widely available in the weather and electricity derivative markets, management uses
available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating the fair value of instruments which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
The Company’s direct use of investment derivatives includes futures, forwards, swaps and option contracts that derive their value from underlying assets, indices, reference rates or a combination of these factors. The Company uses investment derivatives to manage duration and foreign currency exposure for its investment portfolio as well as to add value to the investment portfolio through speculation.
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed benefit (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated and recorded at fair value with changes in fair value recognized in earnings.
Investments that are considered available for sale are carried at fair value. The fair value of investments is based upon quoted market values where available or by reference to broker or underwriter bid indications. The net unrealized appreciation or depreciation on investments, net of tax, is included in “accumulated other comprehensive income
(loss).” Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as investments in affiliates on the Company’s balance sheets and are accounted for under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in its results for the period. Significant influence is deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or greater in closed end funds, limited partnerships, LLC’s or similar investment vehicles. Significant influence is considered for other strategic investments on a case-by-case basis.
Other monetary assets and liabilities denominated in currencies other than the functional currency of the applicable entity are revalued at the exchange rate in effect at the balance sheet date and revenues and expenses are translated at the exchange rate on the date the transaction occurs with the resulting foreign exchange gains and losses recognized in income.
Identifiable intangible assets with finite lives are amortized on a straight-line basis over their estimated useful lives. The Company evaluates the recoverability of its intangible assets whenever changes in circumstances warrant it. If it is determined that an impairment exists, the excess of the unamortized balance over the fair value of the intangible asset will be charged to income at that time.
Intangible assets with an indefinite life and goodwill are not amortized. The Company continues to review the carrying value of goodwill related to all of its investments for any impairment at least annually. If it is determined that an impairment exists, the Company adjusts the carrying value of goodwill to fair value. The impairment charge is recorded in income in the period in which it is determined. See Note 5 for further information, “Goodwill and Other Intangible Assets.”
The reserve for losses incurred but not reported is estimated by management based on loss development patterns determined by reference to the Company’s underwriting practices, the policy form, type of program and historical experience. The Company’s actuaries employ a variety of generally accepted methodologies to determine estimated ultimate loss reserves, including the “Bornhuetter-Ferguson incurred loss method” and frequency and severity approaches.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“FAS”) No. 123, Accounting for Stock-Based Compensation (“FAS 123”), as amended by FAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (“FAS 148”), 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 FAS 123 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, 2006, the Company had several stock based Performance Incentive Programs, which are described more fully in Note 21, “Share Capital.” Stock-based compensation issued under these plans generally have a life of not longer than ten years and vest as set forth at the time of grant. Options currently vest annually over four years from the date of grant. The Company recognizes compensation costs for stock options and restricted stock on a straight-line basis over the requisite service period (usually the vesting period) for each award.
The Company adopted FAS 123(r) effective January 1, 2006 using the modified-prospective method to account for share-based payments made to employees. The modified-prospective method is similar to the modified-prospective method described in FAS 148. Under this method, compensation cost is recognized beginning with the effective date (a) based on the requirements of FAS 123(r) for all share-based payments granted after the effective date and (b) based on the requirements of FAS 123(r) for all awards granted to employees prior to the effective date of FAS 123(r) that remain unvested on the effective date.
For all periods presented prior to 2006, and for all options granted prior to January 1, 2003, the Company accounted for stock option grants under the recognition and measurement principles of APB 25 and related interpretations and accordingly, recognized no compensation expense for these stock options granted to employees. The following table illustrates the effect on earnings per share for the years ended December 31, 2005 and 2004, if the Company had applied the fair value recognition to all of its stock-based employee compensation:
In April 2006, the FASB issued FSP FIN 46(R)-6, Determining the Variability to be Considered in Applying FIN 46(R), which states that the variability to be considered when applying FIN 46(R) should be based on an analysis of the design of an entity, which entails analyzing the nature of the risks in the entity, determining the purpose for which the entity was created and determining the variability the entity is designed to create and pass along to its interest holders. Typically, assets and operations of the entity create the variability (and thus are not variable interests), while liabilities and equity interests absorb that variability (and thus, are variable interests). The role of a contract or arrangement in the design of the entity, regardless of its legal form or accounting classification, shall dictate whether that interest should be treated as creating or absorbing variability for the entity. The guidance in this FSP was applied as of July 1, 2006, and did not have a material impact on the Company’s financial condition or results of operations but now forms an important part of the Company’s evaluation of any relevant structures.
In June 2006, the FASB ratified a consensus on the EITF Issue No. 06-03 related to the classification of certain sales, value added and excise taxes within the income statement. This EITF would become effective for the Company in the first quarter of our fiscal year 2007. The Company is in the process of evaluating the impact of this EITF on disclosures relating to presentation of such taxes on the statement of operations.
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 must be applied beginning
In September 2006, the Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin No. 108 (“SAB 108”), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. SAB 108 is effective for companies with fiscal years ending after November 15, 2006 and was adopted by the Company as of December 31, 2006. This guidance did not have a material impact on the Company’s financial condition and results of operations.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurements (“FAS 157”) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, FAS 157 does not require any new fair value measurements. FAS No. 157 will be effective for interim and annual financial statements issued after January 1, 2008. The Company is currently evaluating the impact of FAS 157; however, it is not expected to have a material impact on the Company’s financial condition and results of operations.
In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities. This FASB Staff Position (FSP) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing basic earnings per share (EPS) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, Earnings per Share. A share-based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be included in the computation of basic EPS pursuant to the two-class method. The guidance in this proposed FSP would be effective in the first reporting period beginning after the FASB posts the final FSP to its website. All prior period EPS data will have to be adjusted retrospectively to reflect the provisions of the FSP. Under the terms of the Company’s restricted stock awards, grantees are entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return these dividends in the event the unvested awards are forfeited in the future. Accordingly, this FSP will have an impact on the Company’s EPS calculations should the FASB issue the proposed guidance as final during 2007. The Company is currently evaluating the potential impact of this guidance.
The Company is aware of the SEC’s review of the loss reserving practices of the financial guaranty industry. The Company recognizes that there is diversity in practice among financial guaranty insurers and reinsurers with respect to their accounting policies. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60 “Accounting and Reporting by Insurance Enterprises” (“FAS 60”) does not specifically address the unique characteristics of financial guaranty insurance contracts. Consequently, the accounting principles applied by the industry have evolved over time and incorporate the concepts of both short-duration and long-duration contracts accounting under the provisions of FAS 60 and other accounting literature such as FAS 5 and EITF 85-20. In June 2005, the FASB undertook a project to review this matter and provide guidance for the accounting for financial guaranty insurance contracts under which it will consider claims liability recognition, premium recognition, and the related amortization of deferred policy acquisition costs. An exposure draft is expected to be issued by the FASB during the first quarter of 2007. The Company will continue its loss reserving methodology as noted in Note 2 (k) until further guidance is provided by the SEC or FASB. The Company had reserves for financial guaranty insurance contracts of $262.7 million and $173.7 million at December 31, 2006 and 2005, respectively.
In addition, in 2006 the Company made a contribution to SCA of $6.2 million relating to certain long-term compensation previously awarded by the Company to newly transferred SCA employees under its long-term compensation plans.
Subsequent to the completion of the IPO, the Company owns 63% of the outstanding common shares of SCA, although there are certain limitations on the Company’s voting rights. These limitations were put into place in response to increased rating agency desire for greater independence of XL Capital Assurance Inc. (“XLCA”) and XL Financial Assurance Ltd. (“XLFA”), in order to address the differential between the triple-A ratings of these two companies and the remaining affiliated companies within the XL Capital Ltd group. The principal two limitations are as follows:
47.5% of the aggregate voting power of all common shares entitled to vote on such matters, except with respect to elections of all directors (including independent directors) where the votes conferred by the common shares owned by the Company may not exceed 50.1% of the aggregate voting power of all common shares entitled to vote. In this respect, it is relevant that for all matters, the aggregate voting power of any other individual shareholder is limited to a maximum of 9.5% of the aggregate voting power of all common shares entitled to vote. It is further relevant that none of these voting restrictions shall apply to up to three non-affiliated transferees of shares from the Company; and
In connection with the primary IPO of SCA shares, SCA issued 18,009,119 common shares at $20.50 per share for proceeds, net of offering costs, of approximately $342.2 million. In addition upon completion of the secondary public offering of 5,430,774 shares previously held by the XL Insurance (Bermuda) Ltd, the Company received proceeds, net of offering costs, of approximately $104.7 million. The transaction resulted in a pre-tax reduction of the Company’s shareholders’ equity of $33.7 million, representing the difference between the carrying value of 100% of SCA immediately prior to the IPO and the sum of the secondary proceeds and the remaining carrying value of the Company’s ownership interest in SCA subsequent to the IPO; as well as, other costs and taxes incurred on the transaction. The portion of the reduction related to the primary offering of shares by SCA of $30.1 million was recorded as a direct reduction to shareholders’ equity, while the portion of the reduction related to the shares sold in the secondary offering of $3.6 million was included in realized gains (losses) in the accompanying statement of operations. In addition, the Company incurred income tax expenses of $6.0 million principally related to the transfer of XLCA to XL Insurance (Bermuda) Ltd, prior to the contribution of XLCA to SCA.
The combined impact of the sale on net income was a pre and post-tax loss of $6.8 million and $12.8 million, respectively.
Investment assets related to the Company’s life and financial operations are held in separately identified portfolios. Net investment income from these assets is included in net income from life operations and contribution from financial operations, respectively.
Company’s investment in Primus Guaranty Ltd. (“Primus”) and (vi) legacy financial guaranty business and other transactions not transferred to SCA.
This includes net realized gains on investments of $241.9 million, net realized and unrealized losses on investment and other derivatives of $16.6 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss).
This includes net realized gains on investments of $246.5 million, net realized and unrealized gains on investment and other derivatives of $24.0 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss).
Amortization of intangible assets includes $2.7 million related to an acquired block of business expensed through acquisition costs.
This information primarily related to loss reserves, adjustment and reinstatement premiums, reinsurance balances payable and receivable and other assets and liabilities. Once the final excess purchase price was known, the Company amended the amount attributed to goodwill by $171.0 million. The agreement reached with WSIC as to the final purchase price and related adjustments represents the completion of the Company’s allocations to the fair value of net assets. Any subsequent adjustments to the carrying value will be reflected in income in the year in which the adjustments are made.
The revised fair value of significant assets and liabilities acquired by the Company includes $89.4 million of cash, $2.2 billion of invested assets, $1.3 billion of premiums receivable, $1.5 billion of unpaid losses and loss expenses recoverable, $2.8 billion of unpaid losses and loss expenses, $885 million of unearned premiums and $506 million of reinsurance balances payable. The contractual post-closing protection was considered in these fair value estimates.
Net realized gains and losses in 2006 and 2005 included a loss of $151.4 million and $53.2 million, respectively, relating to certain fixed income, equity securities and other investments where the Company determined that there was an other than temporary decline in the value of those investments.
The total amount of other than temporary declines in value in 2006 related to $133.2 million on fixed income securities and $2.8 million on equity securities, and $15.4 million on other investments.
The following is an analysis of how long each of those securities at December 31, 2005 had been in a continual unrealized loss position:
The contractual maturities of fixed maturity securities 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.
At December 31, 2006 and 2005, approximately $142.4 million and $377.4 million, respectively, of securities included in investments available for sale were loaned to various counter-parties through the Company’s securities lending program. At December 31, 2006 and 2005, approximately $147.2 million and $386.5 million, respectively, of cash collateral held in connection with these loans, is included in cash and cash equivalents, with a corresponding liability reflected in net payable for investments purchased.
At December 31, 2006 and 2005, approximately $698.1 million and $603.8 million, respectively, of securities were on deposit with various U.S. state or government insurance departments in order to comply with relevant insurance regulations.
During 2006, the Company sold its interest in FrontPoint Partners LLC, an integrated alternative asset firm, resulting in equity earnings of $41.7 million. During 2004, the Company sold its interest in Pareto Partners L.P. and its affiliated entities, a currency overlay and fixed income manager, resulting in income of $35.4 million.
See Note 19(c), “Commitments and Contingencies - Investments in Affiliates” for further information regarding commitments related to investment in affiliates.
The Company regularly reviews the performance of these other investments. The Company recorded losses of $15.4 million, $0.02 million and $0.4 million in the years ended December 31, 2006, 2005 and 2004, respectively, due to other than temporary declines in values of these other investments.
Net losses and loss expenses incurred for general and financial operations are comprised of:
During 2005, net prior year reserves across the Reinsurance segment developed adversely by $94 million. Reserve strengthening of $267 million in casualty and professional lines was partially offset by releases in other lines of business of $173 million. The casualty strengthening is primarily attributable to workers’ compensation, umbrella liability and certain professional lines of business written in the Company’s North American operations. The reserve releases relate primarily to the property line where releases of $136.0 million occurred across all business units globally in the 2002 to 2004 underwriting years. Releases also occurred in the marine and aviation classes of business across the Reinsurance segment.
The majority of the workers’ compensation reserve increase during 2005 was related to an XLRA working layer program written across multiple underwriting years with a single cedant. This program was not renewed at the end of 2001. Other than this program, XLRA has not written significant working layer workers’ compensation business. The remaining source of the Workers’ Compensation reserve strengthening relates to an update of the mortality tables used in our tabular reserving methodology.
During 2004, net prior year reserves across the Reinsurance segment developed favorably by $24 million. Releases of $144 million net in the property, aviation, marine and other lines of business were partially offset by strengthening of casualty and accident and health reserves amounted to approximately $120 million. Property catastrophe and property other reserve releases totaled approximately $95 million net related primarily to the 2002 and 2003 underwriting years where loss experience has been exceptionally good for the property line. The strengthening of casualty reserves totaled $75 million and related most significantly to professional liability reserves in the London branch which were strengthened by $32 million for Enron and Worldcom claims. The accident & health reserve strengthening of $45 million relates to a portfolio of business underwritten by certain of the Company’s Lloyd’s syndicates.
The Company has experienced significant adverse development in the casualty reinsurance business for the last several years prior to 2006 and there can be no assurance that conditions and trends that have affected the development of liabilities in the past will not continue.
During 2006, net adverse development totaled $28.3 million which primarily related to adverse Hurricane Rita development on a structured property and casualty contract.
Total increases in previously identified financial guaranty case basis reserves during 2006 was $38.9 million.
Total increases in previously identified financial guaranty case reserves during 2006 was $0.7 million.
The Company’s net unpaid losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2006 and 2005, the reserve for potential non-recoveries from reinsurers was $218.3 million and $260.7 million, respectively.
During 2006, the Company acquired $40.2 million in losses through a loss portfolio transfer contract written by the Financial lines segment, of which $18.3 million in losses related to asbestos and environmental claims. Given the terms of the policy, the combined aggregate limit on the total acquired reserves is limited to $60.0 million, not including coverage for claims handling costs over a defined period.
At December 31, 2006, the use of different assumptions within the model could have a material effect on the bad debt provision reflected in the Company’s Consolidated Financial Statements. To the extent the creditworthiness of the Company’s reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than the Company’s bad debt provision. Such an event could have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
Deposit liabilities include both reinsurance deposits and guaranteed investment contract deposits. The Company has entered into certain reinsurance policies with cedants that transfer insufficient risk under FAS No. 113 to be accounted for as insurance or reinsurance transactions. The Company has also entered into investment contracts such as guaranteed investment contracts and funding agreements that do not meet the definition of an insurance contract under FAS No. 97. These contracts are sold with a guaranteed rate of return. The proceeds are then invested with the intent of realizing a greater return than is called for in the investment contracts. These certain structured property and casualty reinsurance agreements, guaranteed investment contracts and funding agreements have been recorded as deposit liabilities and are matched by an equivalent amount of investments. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the ultimate liability. The Company establishes an initial accretion rate at inception of the contract, which is reviewed and adjusted periodically based on claims activity. Deposit liabilities are initially recorded at an amount equal to the assets received.
Interest expense of $350.1 million, $227.7 million and $148.6 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2006, 2005 and 2004, respectively.
“Commitment” and “In Use” data represent December 31, 2005 accreted values.
On August 4, 2006, SCA closed a new $500 million syndicated letter of credit facility. The new facility has a tenor of 5-years and is only available for SCA and its subsidiaries. $250 million is available in the form of revolving credit and the remaining $250 million is available for letters of credit.
In December 2005, the Company issued 29.8 million 7.0% Equity Security Units (the “7.0% Units”) in a public offering. The Company received approximately $722.7 million in net proceeds from the sale of the 7.0% Units after deducting underwriting discounts. Each 7.0% Unit has a stated amount of $25 and consists of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Class A Ordinary Shares on February 15, 2009 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due February 15, 2011 with a principal amount of $1,000. The senior notes are pledged by the holders to secure their obligations under the purchase contract. The number of shares issued under the purchase contract is contingently adjustable based on, among other things, the share price of the Company on the stock purchase date and the dividend rate of the Company. The Company will make quarterly payments at the annual rate of 1.75% and 5.25% under the purchase contracts and senior notes, respectively. For all periods reported, the Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In February 2009, the senior notes will be remarketed whereby the interest rate on the senior notes will be reset in order to generate sufficient remarketing proceeds to satisfy the 7.0% Unit holders’ obligations under the purchase contract. If the senior notes are not successfully remarketed, then the Company will exercise its rights as a secured party and may retain or dispose of the senior notes to satisfy, in full, the 7.0% Unit holders’ obligations to purchase its ordinary shares under the purchase contracts.
In November 2005, the Company repaid its 7.15% senior notes on maturity.
The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 11 million. The Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the 6.5% Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of the Company’s ordinary shares is above the threshold appreciation price of $93.99 per share. Because the average market price of the Company’s ordinary shares during the period the 6.5% Units were outstanding was below this price, the shares issuable under the purchase contracts were excluded from the computation of net income per ordinary share assuming dilution for the twelve month periods ended December 31, 2006 and 2005.
In April 2001, the Company issued at par $255.0 million of 6.58% Guaranteed Senior Notes due April 2011 through a private placement to institutional investors. Proceeds of the debt were used for general corporate purposes.
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. The commercial facilities are scheduled for renewal during 2007 through 2011. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedants with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedants. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
Under the Company’s ten-year private placement notes described above, in the event that the Company fails to maintain a financial strength rating of at least “A” from A.M. Best or XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A” from S&P, an event of default would occur. The Company and its subsidiaries currently have an “A+” (stable) rating from A.M. Best and “A+” (stable) from S&P.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries in Bermuda fall below “A” (as measured by the financial strength rating from A.M. Best at any time), the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the
Credit derivatives are entered into in both financial operations and the Company’s investment portfolio and are recorded at fair value. Valuation of investment related credit derivatives is based on portfolio manager valuations. In determining the fair value of credit derivatives written within financial operations, management differentiates between investment and non-investment grade exposures and models them separately. Management estimates fair value for investment grade exposures by monitoring changes in credit quality and selecting appropriate market indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value. For credit derivatives that are non-investment grade appropriate market indices are not readily available. Accordingly, the Company uses an alternative fair value methodology.
A portion of the Company’s fixed debt is hedged against changes in the applicable designated benchmark interest rate. In addition, interest rate swaps are used to hedge the changes in fair value of certain fixed rate liabilities and fixed maturity securities due to changes in the designated benchmark interest rate. At December 31, 2006, 2005, and 2004, contracts designated as fair value hedges were in a net unrealized gain position of $28.1 million, $23.5 million, and $13.4 million, respectively. As a result of the fair value hedges, deposit liabilities were decreased by $13.6 million at December 31, 2006 and increased by $27.6 million and $19.9 million, at December 31, 2005, and 2004, respectively. These interest rate swap hedges resulted in a net increase in net investment income (net of interest expense) of $5.0 million for the year ended December 31, 2006, and a net decrease of $2.2 million and $10.4 million, for the years ended December 31, 2005 and 2004, respectively. The ineffective portion of the hedges amounted to $5.5 million as part of net realized gains at December 31, 2006, while the ineffective portion of the hedges amounted to $5.0 million and $1.8 million as part of net realized losses at December 31, 2005, and 2004, respectively.
In August 2004, the Company entered into a treasury rate guarantee agreement in anticipation of the issuance of fixed-rate debt. This transaction, which met the requirements of a cash flow hedge of a forecasted transaction under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, was entered into to mitigate the interest rate risk associated with the subsequent issuance of $300.0 million of 5.25% Senior Notes due September 15, 2014 (see Note 14 above). The loss on the settlement of the treasury rate guarantee transaction on August 18, 2004 of $6.3 million was charged to Accumulated Other Comprehensive Income and is being amortized to interest expense over the 10-year term of the related debt.
In 2002, the Company entered into a treasury rate lock agreement with the underwriters of the 6.50% Guaranteed Senior Notes due 2012 (2001: 6.58% Guaranteed Senior Notes due 2011). The Notes were priced using a margin over the yield of a U.S. Treasury note with a similar maturity. The treasury rate lock agreement was designed to eliminate underlying pricing risk of the Company’s debt that would have resulted from an increase in the yield of
The Company also uses bond and stock index futures to add value to the portfolio where market inefficiencies are believed to exist, to equitize cash holdings of equity managers and to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities. These instruments are marked to market on a daily basis and changes in fair values are recorded through net realized and unrealized gains and losses on derivative instruments. The Company measures potential losses in fair values using various statistical techniques.
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed benefit (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities; as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value with changes in fair value recognized in earnings through net realized and unrealized gains and losses on derivative instrument.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of its foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”) with Stoneheath Re (“Stoneheath” or the “Issuer”). The net effect of these agreements to the Company is the creation of a contingent put option in the amount of $350.0 million in the aggregate. The agreements provide the Company with a Reinsurance Collateral Account in support of certain Covered Perils named in the Reinsurance Agreement. The initial Covered Perils will include United States wind, European wind, California earthquake and terrorism worldwide. After an initial three-month period, the covered perils as well as the attachment points and aggregate retention amounts may be changed by the Ceding Insurers in their sole discretion. This may result in a material increase or decrease in the likelihood of payment under the Reinsurance Agreement. On each date on which a Ceding Insurer withdraws funds from the Reinsurance Collateral Account, the Company shall issue and deliver to the Issuer an amount of XL Capital Ltd Series D Preference Shares having an aggregate liquidation preference that is equal to the
In December 2004, XL Financial Assurance Ltd. (“XLFA”) entered into a put option agreement and an asset trust expense reimbursement agreement with Twin Reefs Asset Trust (the “Asset Trust”). The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase XLFA’s non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. XLFA is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B Preferred Shares of XLFA are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the asset trust expense reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 9, 2009, or under certain defined circumstances, such as the failure of XLFA to pay the put option premium when due or bankruptcy. The put option is recorded at fair value with changes in fair value recognized in earnings.
In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”). These facilities were increased to $500.0 million in June 2003. The proceeds of advances under the Credit Facilities were used to fund a trust account to collateralize the reinsurance obligations of the Company under an intercompany quota share reinsurance agreement. The Company could face additional obligations under the Credit Facilities prior to the stated maturity of February 25, 2008, if certain events were to occur, including, but not limited to the Company’s insolvency, withdrawal of assets from the Regulation 114 trust by the ceding company, the downgrade of the Company’s credit ratings below certain specified levels, or the failure of the agent to have a first priority perfected security interest in the collateral posted by the Company. At maturity, the Company will be obligated to make payments in an amount equal to the principal and accrued interest outstanding under the Credit Facilities. The issued securities and the Company’s repayment obligations are recorded as a net balance on the Company’s balance sheet because the Company has a contractual legal right of offset. In the event that in the future
The Company provides and reinsures financial guaranties issued to support public and private borrowing arrangements. Financial guaranties are conditional commitments that guarantee the performance of an obligor to a third party, typically the timely repayment of principal and interest. The Company’s potential liability in the event of non-payment by the issuer of the insured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable (“insurance in force”) on such insured obligation. In synthetic transactions, the Company guarantees payment obligations of counterparties under credit derivatives. The future value of installment premiums for such guarantees totaled approximately $1,030.2 million and $652.0 million at December 31, 2006 and 2005, respectively. The range of maturity of the insured obligations is one to thirty-five years. The Company does not record a carrying value for future installment premiums as they are recognized over the term of the contract.
Other includes Canada, France, Germany, South Korea, Chile, Australia, Japan, Portugal, El Salvador, Jamaica, Panama, Costa Rica, New Zealand, Spain, Italy, Norway, Mexico, and Turkey.
International includes multi-country transactions where there is no majority exposure to any single country.
The creditworthiness of any counterparty is evaluated by the Company, taking into account credit ratings assigned by rating agencies. The credit approval process involves an assessment of factors including, among others, the counterparty, country and industry credit exposure limits. Collateral may be required, at the discretion of the Company, on certain transactions based on the creditworthiness of the counterparty.
The areas where significant concentrations of credit risk may exist include unpaid losses and loss expenses recoverable and reinsurance balances receivable (collectively, “reinsurance assets”), investments and cash and cash equivalent balances. The Company’s reinsurance assets at December 31, 2006 and 2005 amounted to $6.1 billion and $7.5 billion respectively and resulted from reinsurance arrangements in the course of its operations. A credit exposure exists with respect to reinsurance assets as they may be uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
The Company 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 a further $173.6 million over the next five years.
The Company rents space for certain of its offices under leases that expire up to 2022. Total rent expense under operating leases for the years ended December 31, 2006, 2005 and 2004 was approximately $35.8 million, $34.9 million and $31.2 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
At December 31, 2006 and 2005, $3.8 billion and $3.5 billion of letters of credit, respectively, were outstanding, 4.5% and 5.3% of which were collateralized by the Company’s investment portfolios, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements.
Minority interest in equity of consolidated subsidiaries includes third party interests in the common shares in SCA and XL International (Bermuda) Ltd., and preferred stock issued by XLFA. The balance is summarized as follows:
The following table is a summary of Class A ordinary shares issued and outstanding:
In August 2002, the Company issued 9.2 million 8.00% Series A Preference Ordinary Shares at $25.00 per share. Gross proceeds were $230.0 million and related expenses were $7.2 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25.00 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after August 14, 2007, at a redemption price of $25.00 per share. The Company may, under certain circumstances, redeem the Preference Shares before August 14, 2007 at specified redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference Shares are entitled to a class vote ($26.00 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Preference Shares ($25.00 per share redemption price). The proceeds were used for general corporate purposes.
In November 2002, the Company issued 11.5 million 7.625% Series B Preference Ordinary Shares at $25.00 per share. Gross proceeds were $287.5 million and related expenses were $9.1 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25.00 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after November 18, 2007, at a redemption price of $25.00 per share. The Company may, under certain circumstances, redeem the Preference Shares before November, 2007 at specified redemption prices, plus accrued and unpaid dividends. These
circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference Shares are entitled to a class vote ($26.00 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Preference Shares ($25.00 per share redemption price). The proceeds were used for general corporate purposes.
The Company’s 1991 Performance Incentive Program, as amended and restated effective March 7, 2003, provides for grants of non-qualified or incentive stock options, restricted stock, restricted stock units, performance shares, performance units and stock appreciation rights (“SARs”). The plan is administered by the Board of Directors and the Compensation Committee of the Board of Directors. Stock options may be granted with or without SARs. No SARs have been granted to date. Grant prices are established at the fair market value of the Company’s common stock at the date of grant. Options and SARs have a life of not longer than ten years and vest as set forth at the time of grant. Options currently vest annually over four years from date of grant.
Prior to December 31, 2003, all options granted to non-employee directors were granted under the 1991 Performance Incentive Program. Since January 1, 2004, all options have been granted under the Directors Stock &
Option Plan. All options vest immediately on the grant date. Directors may also make an irrevocable election preceding the beginning of each fiscal year to defer cash compensation that would otherwise be payable as his or her annual retainer in increments of 10%. The deferred payments are credited in the form of ordinary share units calculated by dividing 110% of the deferred payment by the market value of the Company’s stock on the date the compensation would otherwise have been paid. These shares are distributed under the terms of the plan. Shares issued under the plan totaled 4,975, 3,814, and 3,819 in 2006, 2005 and 2004, respectively.
A second stock plan is provided for the directors that grants share units equal to their annual retainer divided by the market price of the Company’s ordinary stock on January 1 of each year. These units receive dividends in the form of additional units equal to the cash value divided by the market price on the payment date. Stock units totaling 8,410, 10,027, and 8,351 were issued in 2006, 2005 and 2004, respectively. Total units are granted as shares upon retirement from the Board.
Following the merger with NAC, new option plans were created in the Company to adopt the plans. Options generally have a five or six year vesting schedule, with the majority expiring ten years from the date of grant; the remainder having no expiration. A stock plan is also maintained for non-employee directors. Options expire ten years from the date of grant and are fully exercisable six months after their grant date.
In connection with the SCA IPO, XL Capital and SCA offered eligible employees of SCA the opportunity to exchange all of their outstanding unvested restricted Class A Ordinary Shares of XL Capital and options to purchase Class A Ordinary Shares of XL Capital, which were awarded to such employees under the Company’s plans prior to the IPO, for a long term incentive plan award (the “SCA LTIP Award”) from SCA to be granted under SCA’s Plan (the “Exchange Offer”). An “SCA LTIP Award” is the right to receive a cash payment, or “base amount,” from SCA of no less than 75% of the “target amount” indicated in each offeree’s award letter. Such target amount will be adjusted higher or lower (but in no event lower than the base amount) based on the performance of SCA pursuant to the terms and conditions specified in the Award. The Awards vest as set forth in the applicable Award agreements, and the requisite service period is equivalent to the vesting period. The Awards contain certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability.
Apart from the Exchange Offer, awards of restricted stock and stock options under XL Capital plans to certain senior executives and officers of SCA were involuntarily converted to SCA options and restricted stock awards at the IPO date. The aggregate values of such awards at the IPO date were $2.6 million and $2.2 million for stock options and restricted stock, respectively.
The following is a summary of stock options as of December 31, 2006, and related activity for the year then ended for the Company:
At the effective date of the SCA IPO, SCA awarded 500,428 shares of restricted stock with a weighted average grant date fair value of $20.50. All awards were made to directors and employees. There were no other restricted stock awards made through December 31, 2006. The awards vest as set forth in the applicable award agreements. During the year ended December 31, 2006, SCA recognized approximately $1.2 million of compensation expense related to its restricted stock awards. There were 2,500 shares of restricted stock forfeited and no shares vested during the year ended Dectember 31, 2006. Total unrecognized stock based compensation expense related to non-vested restricted stock was approximately $9.0 million as of December 31, 2006, related to 497,928 options, which is expected to be recognized over a weighted-average period of 4.0 years.
Rights to purchase Class A ordinary shares (the “Rights”) were distributed as a dividend at the rate of one Right for each Class A ordinary share held of record as of the close of business on October 31, 1998. Each Right entitles holders of Class A ordinary shares to buy one ordinary share at an exercise price of $350. The Rights would be exercisable, and would detach from the Class A ordinary shares, only if a person or group were to acquire 20% or more of the Company’s outstanding Class A ordinary shares, or were to announce a tender or exchange offer that, if consummated, would result in a person or group beneficially owning 20% or more of Class A ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of Class A ordinary shares, each Right would entitle the holder (other than such an acquiring person or group) to purchase Class A ordinary shares (or, in certain circumstances, Class A ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company will be entitled to redeem the Rights at $0.01 per Right at any time until the close of business on the tenth day after the Rights become exercisable. The Rights will expire at the close of business on September 30, 2008, and do not have a fair value. The Company has reserved 119,073,878 Class A ordinary shares being authorized and unissued for issue upon exercise of Rights.
A contributory defined benefit pension plan exists in the U.K., but has been closed to new entrants since 1996. Memership comprises six active participants, thirty pensioner participants (receiving payments), and seventy-five terminated and vested participants. Benefits are based on length of service and compensation as defined in the Trust Deed and Rules, and the Plan is subject to triennial fundings valuations, the next of which will be conducted in 2007. Current contribution rates are 14.9% and 3% of pensionable salary for employer and employee respectively. The projected benefit obligation, accumulated benefit obligation and fair value of assets for this plan were $10.8 million, $10.8 million and $9.2 million, respectively, as at December 31, 2006.
For all defined benefit plans the total amount of $9.8 million in pension liability has not yet been recognized as periodic benefit cost and is included in accumulated other comprehensive income as of December 31, 2006.
The income tax provisions for the years ended December 31, 2006, 2005 and 2004 are as follows:
Management is required to determine if there is sufficient positive evidence to conclude that it is more likely than not that the deferred tax asset attributable to its U.K. group net operating losses would be utilized within a reasonable period. Management has reviewed historical taxable income and future taxable income projections for its U.K. group and has determined that in its judgment, the net operating losses will more likely than not be realized as reductions of future taxable income within a reasonable period. Specifically with regard to the U.K. group, management has determined that the projected U.K. group taxable income (using U.K. rules for group loss relief) will be sufficient to utilize the net operating losses of approximately $531.0 million. Management will continue to evaluate income generated in future periods by the U.K. group in determining the reasonableness of its position. If management determines that future income generated by the U.K. group is insufficient to cause the realization of the net operating losses within a reasonable period, a valuation allowance would be required for the U.K. portion of the net deferred tax asset, in the amount of $159.3 million.
Shareholders’ equity at December 31, 2006 and 2005 reflected tax benefits of $1.0 million and $1.8 million, respectively, related to compensation expense deductions for stock options exercised by the Company’s U.S. subsidiaries.
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 which in any twelve month period exceed 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, 2006, and 2005, XLRA had statutory earned surplus of $273.9 million and a statutory earned deficit of $3.6 million, respectively. As a result, XLRA could not declare or distribute any dividends to shareholders in 2006 without obtaining prior approval of the New York Insurance Department. At December 31, 2006, XLRA’s statutory policyholders’ surplus was $2.1 billion, and accordingIy, the maximum amount of dividends XLRA can declare and pay in 2007, without prior regulatory approval, is $213.4 million. At December 31, 2006, one of the seven property and casualty subsidiaries directly or indirectly owned by XLRA had a statutory earned deficit of $14.4 million and three of the seven subsidiaries had statutory deficits ranging from $13.2 million to $46.9 million at December 31,2005.
Unless permitted by the Registrar of Companies, the Company's significant Bermuda based subsidiaries may not pay dividends which would exceed 25% of their total statutory capital and surplus.
During the normal course of business, the Company enters into cost sharing and service level agreement transactions with certain insurance affiliates, which management believes to be conducted consistent with arms-length rates. Such transactions, individually and in the aggregate, are not material to the Company’s financial condition, results of operations and cash flows.
XL Capital Finance (Europe) plc (“XLFE”) is a wholly owned finance subsidiary of the Company. In January 2002, XLFE issued $600 million par value 6.5% Guaranteed Senior Notes due January 2012. These Notes are fully and unconditionally guaranteed by the Company. The Company’s ability to obtain funds from its subsidiaries to satisfy any of its obligations under this guarantee is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which the Company operates including Bermuda, the U.S. and the U.K., among others. Required statutory capital and surplus for the principal operating subsidiaries of the Company was $5.5 billion as of December 31, 2006.
The following is a summary of the unaudited quarterly financial data for 2006 and 2005:
Average stock options outstanding have been excluded where anti-dilutive to earnings per share. Consequently, where there is a net loss, basic weighted average ordinary shares outstanding are used to calculate net loss per share.
In the third quarter of 2005, the Company recorded net loss and loss expenses of $1.5 billion in relation to Hurricanes Katrina and Rita and other natural catastrophes. In the fourth quarter of 2005 that loss estimate was increased by $165.1 million. In addition a loss of $808.9 million was recorded in the fourth quarter of 2005 in relation to the Winterthur Decision.