- - -------- (1) Net income per share is based on the weighted average number of ordinary shares and ordinary share equivalents outstanding for each period as required by Statement of Financial Accounting Standard No. 128. (2) All share and per share information has been retroactively restated to give effect to a one for one stock dividend paid to shareholders of record on July 26, 1996.
XL Insurance Ltd, an insurance company organized under the laws of Bermuda ("XLI"), and its subsidiaries are the Company's principal insurance subsidiaries. XLI was formed in 1986 in response to a shortage of high excess liability coverage for Fortune 500 companies in the United States. In 1990, XLI formed XL Europe Insurance, an insurance company organized under the laws of the Republic of Ireland ("XLE"), to serve European clients. In 1998, XLI acquired Folksamerica General Insurance Company (renamed X.L. Insurance Company of America, Inc.), an insurance company domiciled in the State of New York and possessing property and casualty insurance licenses in approximately 20 states and reinsurance licenses in approximately 14 states, and formed X.L. Risk Solutions, Inc., an insurance company domiciled in the State of Connecticut. XLI also has a representative office in Australia.
The Company's operations at Lloyd's are conducted through The Brockbank Group plc, a company organized under the laws of England, and its subsidiaries (together, "Brockbank"). Brockbank is a leading Lloyd's managing agency which manages five Lloyd's syndicates, two of which are dedicated corporate syndicates ("corporate syndicates") whose capital is provided solely by the Company and its subsidiaries. Mid Ocean acquired 51% of Brockbank in December 1995 and the remaining 49% in August 1997. The two corporate syndicates, which commenced operations with effect from January 1, 1996, underwrite property, marine and energy, aviation, satellite, professional indemnity, U.K. motor and other specialty lines of insurance and reinsurance to a global client base. In 1998, the aggregate premium limit of the two corporate syndicates was approximately $340 million, and the total capacity under management by Brockbank was approximately $900 million. As a managing agency, Brockbank receives fees and commissions in respect of the underwriting services it provides to syndicates.
In October 1998, the Company sold its 21% interest in Venton Holdings Limited, a Bermuda holding company for the Venton managing agency group at Lloyd's (together, the "Venton Group"). Prior to the sale, subsidiaries of the Company provided reinsurance coverage to the Venton Group, which writes principally professional indemnity, directors' and officers' liability and fiduciary liability insurance coverages.
The insurance subsidiaries have a quota share reinsurance policy with several U.S. reinsurers, of which one is RCRe, covering general liability risks only. Under the terms of this reinsurance, the Company will cede either 20% or 25% of each risk depending upon the underlying limit written. The maximum amount recoverable from the reinsurers will be the ceded percentage of the original policy limit on a per occurrence basis, with an annual aggregate of 225% of the total premium ceded. No single reinsurer participates in excess of 20% of the quota share. All the reinsurers are rated, of which the lowest as rated by S&P is BBB. Effective September 1, 1997, the insurance subsidiaries entered into an excess of loss casualty catastrophe reinsurance contract covering all general liability risks. Under the terms of this policy, the Company is reinsured for $80 million ultimate net loss each occurrence excess of a per occurrence retention, subject to an annual aggregate retention of $110 million. The maximum amount recoverable from the reinsurers will be an annual aggregate of $250 million. For the year ended November 30, 1998, 97.75% of this reinsurance has been placed with twenty three reinsurers, all of which are rated. With the exception of two reinsurers, the lowest as rated by S&P is A-. The other two reinsurers are rated BBB and BB by S&P, representing 3.5% participation on this program.
Employment practices liability coverage is reinsured on a quota share basis one third of the first $75 million to a U.S. insurer and cedes the remaining excess layer of $25 million to a Bermuda based insurer. Both reinsurers are rated, of which the lowest as rated by A.M. Best is A.
The Company cedes 25% of all property risks to a quota share reinsurance treaty purchased from several property reinsurers. GCR and MORe were both participants of this program. All property reinsurers are rated, of which the lowest as rated by S& P is A-.
XL Risk Solutions and CIGNA Risk Solutions are a coordinated initiative between XLI and CIGNA Property & Casualty ("CIGNA"). The product provides combined capacity for traditional casualty and property coverages provided by XLI or CIGNA. Available capacity by line of coverage is $60 million to $200 million depending upon the lines selected. Attachment levels may, in certain situations, be provided below traditional stated levels subject to the underwriting requirements. A quota share arrangement exists between XLI and CIGNA based on pre agreed percentages by line of coverage for blended covers written through XL Risk Solutions. These percentages vary from 12.5% to 90%, but do not exceed XLI's normal capacity on individual lines of cover. XLI may underwrite an account 100% without CIGNA participation.
XLI also offers insurance and reinsurance solutions for complex financial risks. These include financial insurance and reinsurance, credit enhancement, swaps and other collateralized transactions for up to $100 million in limits. While each of these are unique and are tailored for the specific needs of the insured, they are typically multi-year policies. Due to the nature of these types of policies, premium volume as well as profit margin can vary significantly from period to period. The Company has no formal reinsurance coverage for these risks, but may cede a portion of some policies to third parties from time to time.
A significant portion of XLMORe's business underwritten consists of large aggregate exposures to man-made and natural disasters and generally loss experience is characterized as low frequency and high severity. This may result in volatility in the Company's financial results. The Company endeavors to manage its exposures to catastrophic events by limiting the amount of its exposure in each geographic zone worldwide and requiring that its property catastrophe contracts provide for aggregate limits and varying attachment points.
In August 1998, XLMORe placed $200 million of retrocessional property catastrophe cover in a combination reinsurance and capital market swap transaction. The transaction was offered in two tranches and covered the upper layers, with a remote probability of attachment, of XLMORe's hurricane and earthquake exposure in the United States and its territories and possessions in the Caribbean. The risk securitization structure provides retrocessional cover in financial swap form, with claim recovery triggered by catastrophe losses actually incurred by XLMORe, rather than by a catastrophe index or industry size event.
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums assumed are estimated based upon information received from ceding companies and any subsequent
Acquisition costs which vary with and are primarily related to the acquisition of policies, primarily commissions paid to insurance brokers, are deferred and amortized over the period the premiums are earned. Future earned premiums and the anticipated losses and other costs related to those premiums are also considered in determining the level of acquisition costs to be deferred.
The functional and reporting currency of the Company and its subsidiaries is U.S. dollars. Monetary assets and liabilities denominated in foreign currencies are translated at the exchange rate in effect at the balance sheet
The Company accounts for its other investments on a cost basis as it has no significant influence over these entities. Assets are written down to their realizable value where there is a permanent decrease in value. Income is recorded when received.
Intangible assets recorded in connection with the Company's business combinations are amortized on a straight-line basis over the expected life of the related operations acquired. The Company evaluates the recoverability of its intangible assets whenever changes in circumstances warrant. If it is determine that an impairment exists, the excess of the unamortized balance over the fair value of the intangible asset will be charged to earnings.
Unpaid losses and loss expenses includes reserves for unpaid reported losses and loss expenses and for losses incurred but not reported. The reserve for unpaid reported losses and loss expenses has been established by management in consultation with independent legal counsel and ceding companies, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company.
Net investment income is derived from the following sources (U.S. dollars in thousands):
The following represents an analysis of realized and the change in unrealized appreciation (depreciation) on investments (U.S. dollars in thousands):
The Company owned 29.1% of the issued voting shares and 24.8% of the total issued shares of Mid Ocean as at November 30, 1997. The Company accounted for its share of Mid Ocean's earnings to July 31, 1998 on an equity basis. Subsequent to this date, Mid Ocean was acquired by the Company (as previously discussed in note1) and has been consolidated as a wholly owned subsidiary of XL.
In June 1997, XL acquired 21% of Venton from the Trident Partnership L.P., of which XL is a 10.7% limited partner. Venton manages three syndicates at Lloyd's of London which underwrite non-marine, marine and all main classes of business, respectively. On October 23, 1998, XL sold its investment in Venton to an unrelated third party for $ 41.4 million cash, realizing a net gain of $14.1 million.
Reconciliation of unpaid losses and loss expenses (U.S. dollars in thousands):
The 1998 current year losses reflects the inclusion of the operations of Mid Ocean acquired on August 7, 1998. The results include four months of XLMORe and three months of Brockbank. These operations incurred $169 million in gross losses for the reported period. These losses were largely attributable to Hurricane Georges and the SwissAir airline disaster. In addition, losses for Brockbank attach at the primary layers and therefore are more frequent in nature. These losses are also significantly reinsured.
The high level of the 1997 current year incurred losses was due to the fact that three new 1997 casualty indemnity reserves totaling $145 million were established. Historically, such losses have not emerged this quickly. Should actual loss activity prove to be different, these reserves will be adjusted accordingly.
facility remains in place following the merger with Mid Ocean. Letters of credit totaling approximately $223.0 million were outstanding as at November 30, 1998. This amount includes $169.5 million in respect of the Lloyd's corporate syndicates which has been issued in lieu of paid in capital.
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of its non-U.S. dollar fixed maturities and its non-U.S. dollar equity investments on an overlay basis. The fair value of the Company's non-U.S. dollar denominated investments as at November 30, 1998 and 1997 was $535.3 million and $566.1 million, respectively. These contracts are not designated as specific hedges for financial reporting purposes and, therefore, realized and unrealized gains and losses recognized on them are recorded as a component of net realized gains and losses in the period in which they occur. These contracts generally have maturities of three months or less. In addition, where the Company's investment managers are of the opinion that potential gains exist in a particular currency, then a forward contract will not be entered into. At November 30, 1998, forward foreign exchange contracts with notional principal amounts totalling $322.3 million were outstanding. The fair value of these contracts as at November 30, 1998, was $308.4 million with unrealized losses of $13.9 million. Gains of $3.8 million were realized during the year.
The Company attempts to hedge directly the foreign currency exposure of a portion of its non-U.S. dollar fixed maturity investments using forward foreign exchange contracts that generally have maturities of three months or less, and which are rolled over to provide continuing coverage for as long as the investments are held. Where an investment is sold, the related foreign exchange sale contract is closed by entering into an offsetting purchase contract. At November 30, 1998, the Company had, as hedges, foreign contracts for the sale of $17.5. million and the purchase of $0.1 million of foreign currencies at fixed rates, primarily New Zealand dollars (73% of net contract value), Danish Kroner (14%) and Swedish Kroner (13%). The market value of non-U.S. dollar fixed maturities held by the Company as at November 30, 1998 was $19.0 million.
Unrealized foreign exchange gains or losses on foreign exchange contracts hedging non-U.S. Dollar fixed maturity investments are deferred and included in shareholders' equity. As at November 30, 1998, unrealized deferred gains amounted to $0.1 million, and were offset by corresponding decreases in the U.S. dollar value of the investments. Realized gains and losses on the maturity of these contracts are also deferred and included in shareholders' equity until the corresponding investment is sold. As at November 30, 1998, realized deferred losses amounted to $2.0 million.
The Company is exposed to credit risk in the event of non-performance by the other parties to the forward contracts, however the Company does not anticipate non-performance. The difference between the notional principal amounts and the associated market value is the Company's maximum credit exposure.
The Company also invests in a synthetic equity portfolio of S&P Index futures with an exposure approximately equal in amount to the market value of underlying assets held in this fund. As at November 30, 1998, the portfolio held $138.3 million in exposure to S&P 500 Index futures together with fixed maturities, short-term investments and cash amounting to $ 139.5 million. The value of the futures is updated daily with the change recorded in income as a realized gain or loss. For the year ended November 30, 1998, net realized gains from index futures totaled $25.8 million.
The Company's investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification which limit the allowable holdings of any single issue. The Company did not have an aggregate investment in a single entity, other than the U.S. government, in excess of 10% of shareholders' equity at November 30, 1998.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. The primary purpose of these partnerships is to invest capital provided by the partners in various insurance and reinsurance ventures. The Company had invested $33.3 million and $27.2 million as at November 30, 1998 and 1997, respectively, with commitments to invest a further $138.7 million over the next ten years. The Company received income from its investments of $3.6 million and $4.3 million for the years ended November 30, 1998 and 1997, respectively. The Company continually reviews the performance of the partnerships to ensure there is no decrease in the values of its investments. The Company is a limited partner and, as such, does not actively participate in the management of the partnerships.
In 1997, subsidiaries of the Company obtained two unsecured revolving lines of credit of $250 million each, one for 364 days (short-term) and the other for 5 years (long-term), from a syndicate of nine major international banks led by Mellon Bank, N.A. During the year, a total of $505.0 million was borrowed at a weighted average rate of 5.667%. Total interest expense and facility costs amounted to $9.5 million and $7.18 million for the years ended November 30, 1998 and 1997, respectively. As at November 30, 1998, the outstanding balance was $190.0 million drawn under the long-term facility and is repayable within the next twelve months.
Mid Ocean had obtained multi-currency committed lines of credit provided by a syndicate of nine major international banks led by Chase Manhattan Bank, N.A. which provides for unsecured borrowing up to an aggregate amount of $200 million subject to certain conditions. The Mid Ocean facility is split evenly between a 364-day and a 5-year facility. These facilities remained in place following the merger with Mid Ocean. In August 1998, $50 million was borrowed from this facility and lent to XL in connection with the merger with Mid Ocean. This was repaid in November 1998. During this period the weighted average interest rate charged on the loan was 5.760% and the total interest expense amounted to $0.7 million.
The authorized share capital is 999,990,000 ordinary shares, par value $0.01 per share, divided into Class A and Class B ordinary shares. Holders of Class A shares are entitled to one vote for each share held while Class B shares are not entitled to vote. In all other respects, Class A and B shares rank pari passu.
The issuances of Class A shares were in exchange for Mid Ocean shares (26.0 million shares) and FSA shares (1.1 million shares). The issuance of Class B shares was in exchange for the Mid Ocean Class B and Class C shares.
Under this plan, directors may also may 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 $5,000. The deferred payments are credited in the form of share units calculated by dividing 110% of the deferred payment by the market value of the Company's stock at the beginning of the fiscal year. Directors also may elect to receive their annual retainer in the form of shares with a value equal to the amount of their annual fee. Shares issued under the plan totaled 2,737, 3,048 and 4,048 in 1998, 1997 and 1996, respectively.
awards granted in 1998, 1997 and 1996, and net income and earnings per share would have been reduced to the pro-forma amounts indicated below (U.S. dollars in thousands, except per share amounts):
Total stock based compensation recognized in net income was $4.4 million in 1998, $3.2 million in 1997 and $1.3 million in 1996.
- - -------- *Available for grant includes shares which may be granted on either stock options or restricted stock.
The Company's Articles of Association restrict the voting power of any person to less than 10% of total voting power.
Rights to purchase Class A Ordinary Shares were distributed as a dividend at the rate of one Right for each outstanding Class A Ordinary Share held of record as of the close of business on October 31, 1998. Each Right will entitle holders of XL Class A Ordinary Shares to buy one ordinary share at an exercise price of $350.00. The Rights would be exercisable, and would detach from the Class A Ordinary Shares, only if a person or group were to acquire 20 percent or more of XL's outstanding Class A Ordinary Shares, or were to announce a tender or exchange offer that, if consumated, would result in a person or group beneficially owning 20 percent or more of XL's Class A Ordinary Shares. Upon a person or group without prior approval of the Board acquiring 20 percent or more of XL's Class A Ordinary Shares, each Right would entitle the holder (other than such an acquiring person or group) to purchase XL 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. XL 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 initially have a fair value. The Company has initially reserved 119,073,878 Class A Ordinary Shares being authorized and unissued for issuance upon exercise of the Rights.
Under the laws of the Cayman Islands, the use of XL's contributed surplus is restricted to the issuance of fully paid shares (i.e., stock dividend or stock split) and the payment of any premium on the redemption of ordinary shares.
The Company is liable with respect to reinsurance ceded to the extent that any reinsurance company fails to meet its obligation to the Company. The Company regularly monitors the financial condition of its reinsurers and believes there to be no material unrecoverable reinsurance.
Bermuda presently imposes no income, withholding or capital gains taxes, and XL and its Bermuda subsidiaries are exempted until March 2016 from any such future taxes pursuant to the Bermuda Exempted Undertakings Tax Protection Act 1966, and Amended Act 1987.
X.L. Investments (Barbados), Inc. qualifies as an exempted company under the provisions of the International Business Companies Act 1991-24 and as such is subject to a maximum tax rate in Barbados of 2.50%.
Brockbank and XLMORe's London branch office are subject to United Kingdom corporation taxes. Profits of XLMORe's Singapore branch office are subject to Singapore corporation taxes. The German subsidiary of XLMORe is subject to taxation in Germany.
The Company's U.S. subsidiaries are subject to Federal, State and local corporate income taxes and other taxes applicable to U.S. corporations.
The Company's ability to pay dividends is subject to certain regulatory restrictions on the payment of dividends by its subsidiaries. The Company relies primarily on cash dividends from XLI and XLMORe. The payment of such dividends is restricted by applicable law including Bermuda, the United States, the Republic of Ireland and United Kingdom insurance law and regulations, and those promulgated by the Society of Lloyd's.
XLI's and XLMORe's statutory capital and surplus, statutory net income and the minimum statutory capital and surplus required by the Act were as follows (U.S. dollars in thousands):
Under the Act, XLI and XLMORe are classified as a Class 4 insurer and reinsurer, respectively. Therefore they are restricted to the payment of dividends in any one financial year of 25% of the prior year's statutory capital and surplus, unless their directors attest that such dividends will not cause the company to fail to meet its relevant margins. XLI and XLMORe have not been affected by this. XLI could legally have paid dividends in the amount of approximately $1.8 billion, $1.5 billion and $1.1 billion at November 30, 1998, 1997 and 1996, respectively. XLMORe could legally have paid dividends in the amount of approximately $1.3 billion, $403.4 million and $169.5 million at November 30, 1998, 1997 and 1996, respectively.
The Company's U.S. insurance subsidiaries are subject to regulatory oversight under the insurance statutes and regulations of the jurisdictions in which they conduct business. Brockbank, via Lloyd's, is a licensed insurer in the states of Illinois, Kentucky and the U.S. Virgin Islands ("USVI"). It is also an eligible surplus lines writer in all states other than Kentucky and USVI, and an accredited reinsurer in every state other than Michigan. Brockbank Insurance Services, Inc., is a California licensed surplus and special lines broker.
The insurance laws of each state of the United States and of many foreign countries regulate the sale of insurance within their jurisdictions by alien insurers, such as XLI and XLMORe. The Company believes it is not in violation of the insurance laws of any state in the U.S. or any foreign country. From time to time, various proposals for federal legislation within the United States have been circulated which could require the Company to, among other things, register as a surplus lines insurer. The Company believes that generally it could meet and comply with the requirements to be registered as a surplus lines insurer and such compliance would not have a material impact on the ability of the Company to conduct its business. There can be no assurance, however, that the activities of the Company will not be challenged in the future or that the Company will be able to successfully defend against such challenges or that legislation will not be enacted that will affect the Company's ability to conduct its business.
As a result of the Company's ownership of Brockbank, the Company and Brockbank are subject to the regulatory jurisdiction of the Council of Lloyd's (the "Council"). Unlike other financial markets in the UK, Lloyd's is not subject to direct UK government regulation through The Financial Services Act of 1986 but, instead, is self regulating by virtue of The Lloyd's Act of 1982 through bye-laws, regulations and codes of conduct written by the Council, which governs the market. Under the Council, there are two boards, the Market Board and the Regulatory Board. The former is led by working members of the Council and is responsible for strategy and the provision of services such as premium and claims handling, accounting and policy signing. The Regulatory Board is responsible for the regulation of the market, compliance and the protection of policyholders and capital providers. Under the regulations, the approval of the Council has to be obtained before any person can be a "major shareholder" or "controller" of a corporate Name or a managing agency. The Company has been approved as both a "major shareholder" and a "controller" of its corporate Names (the "CCVs") and managing agencies.
The unaudited quarterly financial data for 1998 and 1997 follows (U.S. dollars in thousands, except per share amounts):
The Financial Accounting Standards Board ("FASB") issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", effective for fiscal years beginning after December 15, 1997. This statement established standards for reporting information about operating segments in annual financial statements and requires selected information about operating segments in interim financial reports issued to shareholders. It also established standards for related disclosures about products and services, geographical areas and major customers. Under SFAS No. 131, operating segments are to be determined consistent with the way that management organizes and evaluates financial information internally for making operating decisions and assessing performance. The Company has not yet assessed the affect of the adoption of this accounting standard on its consolidated financial statement disclosures.
On December 2, 1998, the Company announced that it has signed a definitive agreement to acquire all of the outstanding shares of Intercargo Corporation ("Intercargo") for $12 per share, or approximately $88 million. Intercargo, through its subsidiaries, underwrites specialty insurance products for companies engaged in international trade, including U.S. customs bonds and marine cargo insurance. At September 30, 1998, Intercargo had total assets of $165 million and shareholders' equity of $81 million. The transaction is subject to approval by Intercargo's shareholders, regulatory approvals and other customary closing conditions. There can be no assurance that the transaction will be completed or that the terms of the transaction will not be modified prior to completion.
On March 16, 1998, the combination of EXEL and Mid Ocean was announced. The shareholders of the two companies approved the two schemes of arrangement on August 3, 1998 and the Grand Court of Cayman approved the arrangements on August 7, 1998. The Company is the holding company for the new organization, and the reinsurance operations of both companies were combined on August 7, 1998. The transaction, detailed in the joint proxy statement filed with the Securities and Exchange Commission on July 2, 1998, resulted in XL issuing 1.0215 shares for each Mid Ocean share (other than Mid Ocean shares held by EXEL and its subsidiaries), subject to the cash election rights of the two companies' shareholders described therein. Prior to this transaction, EXEL owned approximately 25% of Mid Ocean Class A shares.
This unaudited condensed pro forma financial information should be read in conjunction with the following explanatory notes.
(a) The combination of EXEL and Mid Ocean was accounted for under purchase accounting rules, in accordance with generally accepted accounting practice, whereby the total purchase cost is allocated to the assets and liabilities acquired based on their relative values at the date of acquisition, and the excess of that total purchase cost over the fair values is recorded as goodwill. The fair values ascribed to the individual assets and liabilities are based upon management studies and appraisals.
(b) Included in the pro forma income statements for the year ended November 30, 1998 and 1997 is the financial information of Mid Ocean for the nine months ended July 31, 1998 and the year ended October 31, 1997, respectively. No adjustments have been made to take account of these differing period ends as, in the opinion of management, any such adjustments would not be material.
To the Board of Directors and Shareholders of XL Capital Ltd: