The Company rents space for its principal executive offices under leases that expire up to 2013. Total rent expense for the years ended December 31, 2000, 1999 and 1998 was approximately $18.3 million, $13.0 million and $9.0 million, respectively. In 1997, the Company acquired commercial real estate in Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The total cost of this development, including the land, is expected to be approximately $110.0 million, of which $101.0 million had been spent as at December 31, 2000. It is estimated that the development will be completed in April 2001. See Note 11 to the Consolidated Financial Statements for discussion of the Company's lease commitments.
The selected consolidated financial data below is based upon the Company's fiscal year end of December 31. The selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes thereto presented under Item 8.
(3) 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.
(5) The underwriting expense ratio is the sum of acquisition expenses and operating expenses divided by net premiums earned. Operating expenses relating to the corporate segment and foreign exchange gains and losses have not been included for purposes of calculating the underwriting expense ratio. See Note 3 to the consolidated financial statements for further information.
This "Management's Discussion and Analysis of Results of Operations and Financial Condition" contains forward-looking statements which involve inherent risks and uncertainties, including, but not limited to, business, financial and integration risks associated with the Winterthur International acquisition and the risk that the acquisition will not be consummated. Statements that are not historical facts, including statements about the Company's beliefs and expectations, are forward-looking statements. These statements are based upon current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See "-Cautionary Note Regarding Forward-Looking Statements" for a list of additional factors that could cause actual results to differ materially from those contained in any forward-looking statement.
This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and notes thereto presented under Item 8.
The following table presents an after-tax analysis of the Company's net income for the years ended December 31, 2000, 1999 and 1998 (U.S. dollars in thousands, except per share amounts):
Net income increased in 2000 compared to 1999 due to an increase in net investment income, equity in net income of affiliates and exchange gains and losses. This increase was partially offset by an increase in the underwriting loss. In 2000, the Company incurred after-tax charges of $124.6 million, or $0.98 per share, which included certain reserve adjustments together with employee severance charges and other costs associated with the realignment of the Company's operations and the discontinuation of certain business lines. These charges affected the underwriting results across all of the Company's segments, excluding the financial products and services segment. In 1999, the Company incurred losses of $125.0 million after-tax, or $0.97 per share, as a result of two major European windstorms in December 1999. In addition, 1999 includes an increase to reserves of $95.0 million associated with the merger with NAC. These two factors are the primary reason for the decrease in net income excluding realized gains on investments in 1999 as compared to 1998.
Basic and diluted earnings per share increased in 2000 as compared to 1999 due to both an increase in net income and a reduction in the weighted average number of shares outstanding. The decrease in the weighted average number of shares outstanding in 2000 is a result of the Company repurchasing 5.1 million shares during the year. The decrease in the basic and diluted earnings per share in 1999 over 1998 is due to a reduction in net income.
The loss and loss expense ratio includes the effects of an intercompany stop loss arrangement in place in 2000 and 1999 with a subsidiary in the reinsurance segment. Losses incurred relating to this arrangement were $33.5 million and $100.0 million in 2000 and 1999, respectively. There was no such arrangement in place in 1998. The purpose of this arrangement is to efficiently manage statutory surplus levels across the Company. The higher losses in 1999 were the result of catastrophic losses that occurred in 1999. Had this arrangement not been in place, the loss and loss expense ratio would have been 64.6% and 45.2% in 2000 and 1999, respectively. The increase in the loss ratio in 2000 over 1999 is due to several factors. In 2000, the Company applied higher loss ratios to certain of its casualty lines written in 2000. These loss ratios have been actuarially estimated and reflect the continued negative impact that competitive market conditions have had on rates for these lines of business written in 2000. There was a reduction of loss reserves in 1999 established on the Company's liability lines due to updated actuarially determined
reserve estimates that reflect the favorable development of these lines relating to prior years. Loss reserve adjustments were made in 2000 as discussed previously. Partially offsetting the increases in 2000 are additional reductions in loss reserves relating to liability lines written in prior years.
The small increase in net premiums earned in 2000 over 1999 reflect the growth in business written by XL Brockbank and Denham due principally to an increase in syndicate capacity provided by the Company from approximately 43% to 50% at XL Brockbank and from approximately 43% to 75% at Denham. The Company has increased capacity at Denham to 100% for 2001. Partially offsetting this increase is the reduction in net premiums earned relating to the motor business that was sold effective December 31, 1999. The Company retains the residual liability on this business. In the years ended December 31, 2000 and 1999, net premiums earned on the motor business were $82.8 million and $135.9 million respectively. Net premiums earned relating to the motor business will decline substantially in subsequent years. In addition, net premiums earned were reduced in 2000 relating to additional reinsurance costs recorded by XL Brockbank relating to an outwards stop loss reinsurance policy. Under this policy, additional premiums become payable as losses develop for certain lines of business. Reinsurance costs of $23.3 million, $13.4 million and $7.6 million were incurred for 2000, 1999 and 1998, respectively. Of the cost incurred for 2000, approximately $19.1 million relates to losses on certain business lines that the Company will be exiting as part of the reorganization. Coverage provided by this stop loss reinsurance policy has been significantly reduced for 2001 and while this may reduce reinsurance costs, it exposes XL Brockbank to potentially higher net losses.
The increase in net premiums earned in 1999 compared to 1998 is a result of the acquisition of Brockbank in August 1998. In addition, results for Denham were not significant in 1998.
The decrease in the loss ratio and increase in the expense ratio in 2000 over 1999 primarily reflects the effect of the sale of the motor business. In 1999, the motor business had a loss ratio of approximately 101.1% and an expense ratio of approximately 21.8%. Other business written by XL Brockbank and Denham typically has lower loss ratios and higher commissions than the motor business. The increase in the expense ratio in 2000 was also due to two other factors (i) the reduction in net premiums earned due to the additional reinsurance costs for the stop loss policy. Excluding the effects of this reinsurance cost, the expense ratio would have been 39.0%, 32.1% and 28.5% for 2000, 1999 and 1998, respectively, and (ii) 2000 includes a charge of $7.5 million for employee severance and other costs associated with the realignment of the Company's operations.
The increase in the loss ratio in 1999 over 1998 is due to reserve increases related to adverse development on the U.K. motor business prior to the sale for which the Company still retains residual liabilities.
incurred in 2000, 1999 and 1998, respectively, relating to these policies, where reinsurance recoveries have been recorded of $151.8 million, $65.0 million and $25.0 million, respectively, for each of the years.
Fee income and other in 2000 relates primarily to non-underwriting costs relating to an outward reinsurance contract that did not exist in 1999 or prior.
Net losses and loss expenses incurred in the segment reflect a recovery of $33.5 million and $100.0 million respectively, under an intercompany stop loss arrangement. The loss and loss expense ratio in 2000 and 1999 would have been 75.1% and 87.1% respectively, had this arrangement not been in place. Included in net losses incurred in 2000 are loss reserve adjustments as discussed previously. Excluding the effects of the intercompany stop loss agreement, the loss ratio was higher in 1999 compared to both 2000 and 1998 primarily due to a higher amount of catastrophe losses and a reserve adjustment of $95.0 million relating to the merger with NAC. Loss events in 2000, which included an oil refinery loss in Kuwait, several satellite losses and the Singapore Airlines loss, totaled approximately $95.0 million. Catastrophe losses in 1999 included European windstorms, hailstorms in Sydney, tornadoes in Oklahoma and satellite losses totaling approximately $185.0 million. In addition, there was an increase in the loss ratio in 2000 and 1999 in the casualty reinsurance business in accordance with actuarial estimates, caused to a large extent by the deterioration in premium rates. Actuarial assumptions are used to establish initial expected loss ratios employed in the actuarial methodologies from which the reserve for losses and loss expenses is derived. Such loss ratios are periodically adjusted to reflect comparisons with actual claims development, inflation and other considerations.
The increase in the underwriting expense ratio in 2000 compared to 1999 is primarily due to lower net earned premiums in 2000 relating to the additional stop loss reinsurance costs incurred. Excluding the effect of these costs, the underwriting expense ratio would have been 34.7%, 35.1% and 33.6% for 2000, 1999 and 1998, respectively. Underwriting expenses increased in 1999 over 1998 primarily due to an increase in profit commissions payable to cedents of proportional business written by XL Re. Profitability on some contracts written in earlier underwriting years has increased relative to original estimates, with the resulting increases in profit commissions payable.
The Company's casualty business includes a minimal element of asbestos and environmental claims on business written prior to 1986. The Company's reserving process includes a supplemental evaluation of claims liabilities from exposure to asbestos and environmental claims, including related loss adjustment expenses. However, the Company's loss and loss expense reserves for such exposures, net of reinsurance, as of December 31, 2000, 1999, and 1998 is less than 1% of its total reserves. A reconciliation of the Company's gross and net liabilities for such exposures for the three years ending December 31, 2000 is set forth in Note 7 of the Notes to Consolidated Financial Statements.
Financial guaranty premiums are earned over the life of the exposure, which is generally longer than that in the Company's other operating segments. Certain premiums, such as those received on an installment basis are not earned until the premium is reported. The increase in net premiums earned mainly reflects new business written in 2000.
External investment professionals manage the Company's portfolio under the direction of the Company's management.
As at December 31, 2000 and 1999, total investments and cash, net of the payable for investments purchased, were $9.1 billion, respectively. While there was no significant change between the years, 2000 included the reinvestment of investment income and realized gains, and the receipt of assets relating to the loss portfolio transfers discussed further in "-Financial Condition and Liquidity". These receipts were offset by the transfer of assets to limited partnerships and affiliate investments, claim payments and the repurchase of the Company's shares. As the Company's long-tail casualty business matures over the next three to five years, it is possible that claims payments may increase due to the additional exposure to events that occurred in prior years but have not yet been paid. Funds available for investment may therefore be reduced as compared to prior years due to such increased claims payments. The Company's fixed income investments (including short-term investments and cash equivalents) at December 31, 2000 represented approximately 86.4% of investments available for sale and were managed by several independent investment managers with different strategies. Of the fixed income securities, approximately 88.9% were investment grade, with 61.1% rated Aa or AA or better by a nationally recognized rating agency.
The net payable for investments purchased relates to timing differences as investments are accounted for on a trade date basis. This increased to $1.4 billion at December 31, 2000 from $0.6 billion at December 31, 1999, primarily due to higher investment in certain mortgage-backed securities where the settlement period is generally longer than most fixed income investments.
The increase in investment income in the years presented is primarily due to an increase in the annualized effective yield on the portfolio as the proportion of fixed maturities held increased compared to the prior year. The Company's investment base includes assets relating to deposit liabilities assumed in 2000 and late 1999. Investment income earned on these assets is reduced by the investment expense created by the accretion of these deposit liabilities. Excluding the assets relating to deposit liabilities, the investment base has declined in 2000 compared to 1999 due to claims payments, repurchase of shares and reallocation of assets to other strategic investmnets. However, investment yields have been higher in 2000 compared to 1999, which together with additional income derived from the asset accumulation business, has resulted in higher net investment income.
Net realized investment gains in 1999 and 1998 reflect the strong performance of the equity market. In 1998, equity gains of $150.0 million were realized as some of the Company's equity managers realized gains where they believed that valuations had reached their targets. However, 1999 equity gains were offset by declining fixed income markets that had been strong throughout most of 1998. Due to declining interest rates combined with widening spreads in the corporate and mortgage markets, the fixed income sector allowed the Company opportunities to increase the yield on its investment in 1999.
Corporate operating expenses in 2000 included $5.7 million relating to charges for employee severance and other costs relating to the realignment of Company's operations. 1999 included $45.3 million of charges related to the merger with NAC and 1998 included $17.5 million of charges associated with the merger with Mid Ocean were included in corporate operating expenses. Excluding these charges, the net increase in corporate operating expenses in each of the years presented is due to the increase in the corporate infrastructure necessary to support the growing worldwide operations of the Company.
Decreases in interest expense in 2000 compared to 1999 reflect a reduction in debt carried by the Company through 2000 compared to 1999. The Company extinguished convertible debt assumed in connection with the NAC merger in 1999. In addition, the Company pooled capital with its existing operations as a result of acquisitions in the U.S. in 1999, which facilitated repayment of debt in the third quarter of 1999. This decrease was partially offset by interest expense related to interim borrowings used to finance the repurchase of shares in the year ended December 31, 2000. Increases in interest expense in 1999 compared to 1998 is due to the increase in the average long-term debt outstanding in 1999, which was mainly used to finance the acquisitions of ECS and Intercargo, and the repurchase of shares in both 1999 and 1998.
In 2000, 1999 and 1998, the total amount of net losses paid by the Company was $1.7 billion, $1.1 billion, $0.7 billion, respectively. The increase in 2000 compared to 1999 is due to an increase in the amount of net premiums written by the Company, together with losses paid for the settlement of previously established reserves, particularly catastrophe losses. Paid losses in 2000 also include $74.0 million relating to a commutation payment. The increase in paid losses in 1999 over 1998 is primarily due to the acquisition of Mid Ocean in August 1998. The higher amount of paid claims in 2000 compared to 1999 has contributed to the lower operational cash flow in 2000 as compared to 1999.
Inflation can have an effect on the Company in that inflationary factors can increase damage awards and potentially result in larger claims. The Company's underwriting philosophy is to adjust premiums in response to inflation, although this may not always be possible due to competitive pressure. Inflationary factors are considered in determining the premium level on any multi-year policies at the time contracts are written.
(1) The Company exchanged its investment in Arch Capital (formerly known as Risk Capital Holdings), an affiliate, and $3.6 million in cash for Arch Capital's ownership in Latin American Re and 1.4 million shares and 100,000 warrants of Annuity & Life Re. The Company also acquired the remaining shares of Latin American Re owned by that company's management in December 2000.
(3) The Company invested a further $177.2 million in affiliates, the majority of which related to investment fund affiliates, and a further $55.9 million in limited partnerships and other investments.
During 1999, the Company redistributed assets from investments available for sale and cash for the following investments:
(3) The Company invested a further $91.0 million in limited partnerships and other investments.
See Note 2 to the Consolidated Financial Statements for a discussion on recent accounting pronouncements.
CONSOLIDATED BALANCE SHEETS AS AT DECEMBER 31, 2000 AND 1999 (U.S. dollars in thousands, except share amounts)
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 (U.S. dollars in thousands, except per share amounts)
The Company further expanded into the U.S. in 1999 by completing the acquisition of both Intercargo Corporation and ECS, Inc. Intercargo, renamed XL Specialty, underwrites specialty insurance products for companies engaged in international trade, including U.S. Customs bonds and marine cargo insurance. ECS is an underwriting manager, which specializes in environmental insurance coverages and risk management services.
XL Brockbank, formerly Brockbank, was acquired through the merger with Mid Ocean. XL Brockbank is organized under the laws of the United Kingdom and is a leading Lloyd's managing agency that provides underwriting and similar services to five Lloyd's syndicates. Two of these syndicates are dedicated corporate syndicates whose capital is provided solely by the Company. The two corporate syndicates, which commenced operations on January 1, 1996, underwrite property, marine and energy, aviation, satellite, professional indemnity and other specialty lines of insurance and reinsurance to a global client base. As a managing agency, XL Brockbank may receive fees and commissions in respect of underwriting services it provides to the non-related syndicates. In the fourth quarter of 1999, XL Brockbank sold its two motor insurance businesses, Admiral and Zenith.
The Company formed Sovereign Risk Insurance as a joint venture in 1997. Sovereign is a Bermuda-based managing general agency that writes political risk insurance on a subscription basis on behalf of its shareholders.
In 1996, the Company acquired approximately 30% of Pareto Partners, a firm that specializes in foreign currency management and related services.
These consolidated financial statements include the accounts of the Company and all of its subsidiaries and have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP"). They include the merger with NAC, which occurred in June 1999, and which has been accounted for as a "pooling of interests" under U.S. GAAP. They are based upon the Company's fiscal year end of December 31. Results of operations, statements of position and cash flows include NAC as though it had always been a part of the Company. All significant intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Assets and liabilities of foreign operations whose functional currency is other than the U.S. dollar are translated at year end exchange rates. Revenue and expenses of such foreign operations are translated at average exchange rates during the year. The effect of the translation adjustments for foreign operations, net of applicable deferred income taxes, is included in accumulated other comprehensive income.
The Company recognizes as a component of loss reserves, the loss experience accounts of policyholders for policies written on a multi-year basis where experience accounts are a percentage of premiums net of related losses paid. Interest expense on the experience accounts is charged to investment income. In the event the insured cancels the policy, the return of the experience account is treated as a return premium if there has been no loss notification.
Certain workers' compensation reserves are considered fixed and determinable and are subject to tabular reserving. Such tabular reserves are discounted using an interest rate of 7%.
Short duration contracts entered into by the Company which are not deemed to transfer significant underwriting and/or timing risk are accounted for as deposits, whereby liabilities are initially recorded at the same amount as assets received. An initial accretion rate is established based on actuarial estimates whereby the deposit liability is increased to the estimated amount payable over the term of the contract. This accretion charge is presented in the period as either interest income where the contract does not transfer underwriting risk, or net losses and loss expenses incurred where the contract does not transfer significant timing risk. Policy benefit reserves relate to long duration contracts written by the Company which do not transfer significant mortality or morbidity risks, and are also accounted for as deposits.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31 2000, 1999 AND 1998 (CONTINUED)
The Financial Accounting Standards Board issued Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," (FAS 133) in June 1998. FAS 133 establishes accounting and reporting standards for derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activity. It requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. The Company will adopt FAS 133, as amended, as of January 1, 2001. Credit default swaps issued by the Company meet the definition of a derivative under FAS 133. From January 1, 2001 the Company will record these products at fair value, with the fair value adjustment being recorded in earnings in each period. The level of such adjustments will be dependent upon a number of factors including changes in interest rates, credit spreads and other market factors.
The Lloyd's syndicates write property, marine and energy, aviation and satellite, professional indemnity, liability coverage and other specialty lines, primarily of insurance but also reinsurance.
Reinsurance business written includes treaty and facultative reinsurance to primary insurers of casualty risks, principally: general liability; professional liability; automobile and workers' compensation; commercial and personal property risks; specialty risks including fidelity and surety and ocean marine; property catastrophe; property excess of loss; property pro-rata; marine and energy; aviation and satellite; and various other reinsurance to insurers on a worldwide basis. The Company endeavors to manage its exposures to catastrophic events by limiting the amount of its exposure in each geographic zone worldwide and requires that its property catastrophe contracts provide for aggregate limits and varying attachment points.
The Company evaluates performance of each segment based on underwriting profit or loss. Other items of revenue and expenditure of the Company are not evaluated at the segment level. In addition, management does not allocate assets by segment. The following is an analysis of the underwriting profit or loss by segment together with a reconciliation of underwriting profit or loss to net income:
(2) Net losses and loss expenses for the insurance segment include, and the reinsurance segment exclude, $33.5 million relating to an intercompany stop loss arrangement. Total results are not affected. The loss and loss expense ratio would have been 64.6% and 75.1% and the underwriting results would have been a profit of $55.8 million and a loss of $125.0 million in the insurance and reinsurance segments, respectively, had this stop loss arrangement not been in place.
(2) Net losses and loss expenses for the insurance segment include, and the reinsurance segment exclude, $100.0 million relating to an intercompany stop loss arrangement. Total results are not affected. The loss and loss expense ratio would have been 45.2% and 87.1% and the underwriting results would have been a profit of $125.3 million and a loss of $210.0 million in the insurance and reinsurance segments, respectively, had this stop loss arrangement not been in place.
4. INVESTMENTS (CONTINUED) The cost (amortized cost for fixed maturities and short-term investments), market value and related unrealized gains (losses) of investments are as follows:
5. INVESTMENTS IN AFFILIATES (CONTINUED) The Company's significant insurance affiliate investments at December 31, 2000 include Le Mans Re, Annuity & Life Re ("ALRe") and FSA International, with ownership in those entities at 49%, 11% and 20%, respectively. Insurance affiliates included Risk Capital Holdings at December 31, 1999 and 1998, and Mid Ocean at December 31, 1998.
The Company owned approximately 28% of the issued shares of Arch Capital (formerly Risk Capital Holdings) at December 31, 1999. In 2000, the Company exchanged its shares in Arch Capital and $3.6 million in cash for Arch Capital's ownership in Latin American Re and 1.4 million shares and 100,000 warrants in ALRe, in which the Company had an existing investment. ALRe is a Bermuda-based company and is a leading provider of annuity and life reinsurance to insurance companies in North America. Although the Company has beneficial ownership of only 11% of ALRe's outstanding common shares, XL is deemed to have significant influence as the Company has representatives on ALRe's board of directors. Based upon the quoted market value of ALRe's common shares, the total market value of the Company's investment was $91.1 million compared to a carrying value of $60.8 million at December 31, 2000.
In 1999, the Company signed a joint venture agreement with Les Mutuelles du Mans Assurances Group to form a new French reinsurance company, Le Mans Re. The Company owns a 49% shareholding in the new company, which underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business together with a selective portfolio of life reinsurance business. The Company contributed $31.2 million in additional capital during 2000.
Following the merger, the Company changed its fiscal year end from November 30 to December 31 as a conforming pooling adjustment. No adjustments were necessary to conform NAC's accounting policies, although certain reclassifications were made to the NAC financial statements to conform to the Company's presentation.
In 1999, the Company acquired ECS, an underwriting manager which specializes in environmental insurance coverages and risk management services. ECS commenced underwriting policies on behalf of the Company's insurance and reinsurance subsidiaries effective January 1, 2000.
The Intercargo and ECS acquisitions have been accounted for under the purchase method of accounting. The combined purchase price was $222.8 million and the resulting goodwill of $159.6 million is being amortized over 20 years. Net cash acquired as a result of the acquisition was $49.6 million.
In August 1998, the Company merged with Mid Ocean. Shareholders of Mid Ocean received 1.0215 Ordinary Shares for each Mid Ocean share subject to a cash election option which was taken up of $96 million. The merger with Mid Ocean was accounted for as a purchase under U.S. GAAP and results of operations of Mid Ocean are included from August 1, 1998. The total purchase price was $2.2 billion; the fair value of Mid Ocean's net assets not already owned by the Company was $0.9 billion with the balance of $1.3 billion representing goodwill which is
6. BUSINESS COMBINATIONS AND CHANGE IN FISCAL YEAR END (CONTINUED) being amortized over 40 years. On August 1, 1998, the consolidated balance sheet of Mid Ocean included the following items at fair value:
There has been a high level of paid losses in 2000 due to the settlement of previously established reserves, particularly catastrophe losses as noted below.
The Company's outward reinsurance programs in 2000 have mitigated part of the overall loss development, as shown by the increase in the unpaid losses and loss expenses recoverable, both in the insurance and reinsurance segments. In relation to business lines exited from the Lloyd's operations, additional reinsurance costs of $19.1 million were incurred in respect of expected loss recoveries recorded of $38.0 million. In the reinsurance segment, $80.6 million of additional reinsurance costs were recorded with $151.8 million of expected loss recoveries. The purchase of additional reinsurance in 2000 relates primarily to the casualty lines where the Company has taken advantage of favorable pricing and terms.
Partially offsetting this increase in net incurred losses in 2000 compared to 1999 was a reduction in the number and magnitude of catastrophe losses that occurred. Catastrophe losses in 2000, which included an oil refinery loss in Kuwait, several satellite losses, and the Singapore Airlines loss, totaled approximately $95.0 million. By comparison, 1999 generated approximately $185.0 million of catastrophe losses to the Company, including the European storms in December, hailstorms in Sydney, tornadoes in Oklahoma and satellite losses.
Net losses incurred in 1999 increased significantly over 1998 for a number of reasons. The Company acquired Mid Ocean and Brockbank in August 1998 and therefore only recognized the effect of their operations for five months in 1998. Incurred losses for these entities were approximately $475.0 million in 1999 compared to $260.0 million in 1998. Partially offsetting this, in 1998, the Company incurred approximately $60.0 million in catastrophe losses relating to Hurricane Georges and the SwissAir loss. These losses were incurred in the reinsurance operations.
The increase in paid losses in 1999 reflects the acquisition of Mid Ocean and Brockbank in 1998.
Except for certain workers' compensation liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers' compensation unpaid losses that are considered fixed and determinable and discounts such losses using an interest rate of 7%. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2000 and 1999 were $168.8 million and $85.7 million, respectively. The related discounted unpaid losses and loss expenses were $63.4 million and $28.1 million as of December 31, 2000 and 1999.
The nature of the Company's high excess of loss liability and catastrophe business can result in loss payments that are both irregular and significant. Similarly, adjustments to reserves for individual years can be irregular and significant. Such adjustments are part of the normal course of business for the Company. Conditions and trends that have affected development of liability in the past may not necessarily occur in the future. Accordingly, it is inappropriate to extrapolate future redundancies based upon historical experience.
The Company utilizes reinsurance and retrocession agreements principally to increase aggregate capacity and to reduce the risk of loss on business assumed. The Company's reinsurance and retrocession agreements provide for recovery of a portion of losses and loss expenses from reinsurers and reinsurance recoverables are recorded as assets. The Company is liable if the reinsurers are unable to satisfy their obligations under the agreements.
Two syndicates of banks provide the two five-year facilities and borrowings are unsecured. The amounts of $350.0 million and $299.7 million outstanding at December 31, 2000 and 1999, respectively, relate primarily to the remaining outstanding balance from the $300.0 million borrowed to finance the cash option election available to shareholders in connection with the Mid Ocean acquisition in August 1998, and the $109.7 million borrowed to finance the acquisition of ECS and Intercargo during 1999. The weighted average interest rate on funds borrowed during 2000 was approximately 6.6% and 5.43% during 1999.
The Company has five letter of credit facilities available at December 31, 2000, two from two syndicates of banks, one from a U.K. bank and two from U.S. banks. These facilities include a new $1.0 billion unsecured syndicated letter of credit facility that replaced several syndicated and bilateral facilities provided by U.K. banks, in addition to a new $304.0 million unsecured syndicated facility that replaced several existing facilities supporting the Company's Lloyd's capital requirements. The letter of credit facilities are used to collateralize certain reinsureds' premium and unpaid loss reserves with the Company and to support Lloyd's capital requirements of the Company's corporate syndicates. Of the letters of credit outstanding at December 31, 2000, $160.0 million (1999: $591.0 million) were collateralized against the Company's investment portfolio and $949.0 million (1999: $300.6 million) were unsecured. The Company plans to continue the process of transferring letters of credit into one of the new syndicated facilities.
In connection with these foreign exchange contracts directly hedging foreign currency fixed maturity investments, unrealized foreign exchange gains or losses are deferred and included in accumulated other comprehensive (loss) income. As at December 31, 2000, unrealized losses amounted to $10.2 million. As at December 31, 1999, unrealized losses amounted to $2.0 million and were offset by corresponding increases in the U.S. dollar value of the investments. As at December 31, 2000, realized gains of $14.6 million were recognized in the income statement. As at December 31, 1999, realized losses amounted to $0.7 million.
During the year ended December 31, 2000, the Company used foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the amount of its known claims payable in foreign currencies. These contracts were not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts were recorded in income in the period in which they occurred. As at December 31, 2000 no contracts were outstanding. A loss of $6.8 million was realized in the year in connection with these contracts.
In 2000, the Company used foreign exchange forward contracts to reduce its exposure to premiums receivable denominated in foreign currencies. The forward contract is closely matched with the receivable maturity date. Both the foreign currency receivable and the offsetting forward contract are marked to market on each balance sheet date, with any gains and losses recognized in earnings. At December 31, 2000, the Company had forward contracts outstanding for the sale of $10.0 million of foreign currencies at fixed rates, primarily U.K. Sterling. Losses of $0.2 million were realized during 2000.
The Company rents space for its principal executive offices under leases that expire up to 2013. Total rent expense for the years ended December 31, 2000, 1999, and 1998 was approximately $18.3 million, $13 million,
11. COMMITMENTS AND CONTINGENCIES (CONTINUED) and $9 million, respectively. Future minimum rental commitments under existing leases are expected to be as follows:
A second stock plan, intended to replace the directors' "Retirement Plan for Non-Employee Directors," provides for the issue of share units equal to the amount that would have been credited to the Retirement Plan, divided by the market price of the Company's 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 13,237, 1,217 and 5,531 were issued for in 2000, 1999 and 1998, respectively.
As a result of the merger with Mid Ocean during August 1998, 791,573 Mid Ocean options were converted to options of XL Capital.
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation." Had the Company adopted the accounting provisions of SFAS No. 123, compensation costs would have been determined based on the fair value of the stock option awards granted in 2000, 1999 and 1998, and net income and earnings per share would have been reduced to the pro-forma amounts indicated below:
13. RETIREMENT PLANS (CONTINUED) At NAC, a qualified non-contributory defined benefit pension plan exists to cover substantially all its U.S. employees. This plan also includes a non-qualified supplemental defined benefit plan designed to compensate individuals to the extent their benefits under the Company's qualified plan are curtailed due to Internal Revenue Code limitations. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee's last ten years of employment. Under these plans, the Company's policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. The contribution level is determined by utilizing the entry age cost method and different actuarial assumptions than those used for pension expense purposes. The projected benefit obligation, accumulated benefit obligation and fair value of the assets for this plan with accumulated benefit obligations in excess of the plan assets were $21.3 million, $12.6 million and $12.3 million, respectively, as of December 31, 2000 and $16.6 million, $10.0 million and $11.0 million, respectively as of December 31, 1999. The discount rates used in determining the actuarial present value of benefit obligations were 7.25% and 7.75% for 2000 and 1999, respectively. The rate of increase for future compensation levels was 6.0% for 2000 and 6.5% for 1999. The assumed rate of return on plan assets was 9.0% for both 2000 and 1999.
Under the laws of the Cayman Islands, the use of the Company's contributed surplus is restricted to the issue of fully paid shares (i.e. stock dividend or stock split) and the payment of any premium on the redemption of ordinary shares.
Under current Cayman Islands law, the Company is not subject to any taxes in the Cayman Islands on either income or capital gains. The Company has received an undertaking that, in the event of any such taxes being imposed, the Company will be exempted from Cayman Islands income or capital gains taxes until June 2018.
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 provision for federal income taxes has been determined on the basis of the income of each of the Company's U.S. subsidiaries as if a tax return has been prepared on an individual company basis. Should the U.S. subsidiaries pay a dividend to the Company, withholding taxes will apply.
Bermuda presently imposes no income, withholding or capital gains taxes and the 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.
The income tax provision in the consolidated statement of income gives effect to the permanent differences between financial and taxable income as applied for each relevant subsidiary. Due to the fact that the Company and certain subsidiaries are not subject to direct U.S. income taxes and that certain U.S. subsidiaries have tax-exempt income, the Company's effective income tax rate for its U.S. operation is less than the statutory U.S. Federal tax rate.
Significant components of the provision for income taxes attributable to operations were as follows:
17. TAXATION (CONTINUED) The U.S. subsidiaries current U.S. taxable income for the years ended December 31, 2000 and 1999 is based on regular taxable income. The current U.S. tax expense for the year ended December 31, 1998 is based on alternative minimum taxable income.
Net taxes received in the year ended December 31, 2000 were approximately $13.3 million. In the years ended December 31, 1999 and 1998, net taxes paid were approximately $30.2 million and $31.2 million, respectively. The Company's net current tax asset included in "other assets" in the accompanying financial statements was $14.3 million at December 31, 2000.
At December 31, 2000, the Company's management concluded that all deferred tax assets are more likely than not to be realized and consequently, no valuation allowance has been provided. At December 31, 1999, the Company's management established a valuation allowance for certain deferred tax assets.
Under The Insurance Act, 1978, (as amended by the Insurance Act Amendment 1995) amendments thereto and related regulations of Bermuda, the Company's Bermuda subsidiaries, the most significant of which are XL Insurance and XL Re, are required to prepare statutory financial statements and to file in Bermuda a statutory financial return. The Act also requires these companies to maintain certain measures of solvency and liquidity during the year.
XL Insurance's and XL Re's statutory capital and surplus, statutory net income and the minimum statutory capital and surplus required by the Act were as follows:
Consolidated statutory net income and surplus of NAC Re, as reported to the insurance regulatory authorities, differs in certain respects from the amounts as prepared in accordance with GAAP. The main differences between statutory net income and GAAP income relate to deferred acquisition costs, deferred income taxes and amortization of intangible assets. The main differences between statutory surplus and shareholders' equity, in addition to deferred acquisition costs and deferred income tax net assets, are intangible assets, unrealized appreciation on investments, and any unauthorized/authorized reinsurance charges.
NAC Re is subject to the New York insurance law, which imposes certain restrictions on the payment of cash dividends and tax reimbursements. Generally, NAC Re may pay cash dividends only out of statutory earned surplus. However, the maximum amount of dividends that may be paid in any twelve month period without the prior approval of the New York Insurance Department is the lesser of net investment income or 10% of statutory surplus as such terms are defined in the New York insurance law. Statutory earned deficit at December 31, 2000 and 1999 was $12.2 million and $27.7 million, respectively. Consequently, NAC Re cannot make a dividend distribution at this time.
XL Europe is permitted to underwrite risks throughout the European Community (subject to certain restrictions) pursuant to the "Third Directive" relating to non-life insurance. XL Europe's head office is in Ireland and it is subject to regulation under Irish regulatory authority. The principal legislation and regulations governing the insurance activities of Irish insurance companies are the Insurance Acts 1909 to 1990 (the "Irish Acts") and a comprehensive network of regulations and statutory provisions empowering the making of regulations of which the most relevant are the European Communities (Non-Life Insurance) Regulations, 1976, the European Communities (Non-Life Insurance
XL Capital announced on February 15, 2001 that it has agreed to purchase Winterthur International from Winterthur Swiss Insurance Company ("Winterthur"), a subsidiary of the Credit Suisse Group ("CSG"). The Company will be purchasing a combination of insurance companies and selected Winterthur International insurance portfolios. The all-cash transaction is valued at approximately $600.0 million and may be funded by the Company with a combination of current resources and external financing. Winterthur International is the international, large commercial account property and casualty insurance business of Winterthur. Winterthur International operates in 27 countries, has more than 1,000 employees and in 2000 had gross premiums written and net premiums earned of approximately $1.3 billion and $600.0 million, respectively. In terms of premium volume, Winterthur International's top five markets are the U.K., Switzerland, Germany, the U.S. and France. As at September 30, 2000, Winterthur International (including certain operations to be retained by CSG) had investment assets of approximately $1.0 billion.