(U.S. dollars in thousands, except share and per share amounts and ratios)
During 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 relation to insurance and reinsurance, downward pressure on rates across most non-catastrophe exposed lines continued throughout 2005 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.
Subsequent to the unprecedented catastrophic losses in 2005 and into the 2006 first quarter renewals, the market in general has seen an improvement in terms and conditions as well as pricing, in particular in geographic territories and classes impacted by the catastrophe losses. Casualty and professional lines, which have seen significant price reductions in 2004 and 2005, have begun to stabilize. In the Reinsurance segment, however, these improvements have been offset somewhat by increased ceding company retentions which is common in a hardening market. While the Company is not focused on top line premium growth unless it is profitable and meets demanding standards and internal hurdle rates, the Company’s expectation is for flat earned premium growth for the full year of 2006, with insurance contributing flat to low single digit growth and reinsurance contributing flat to mid-single digit declines.
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 both 2005 and 2004, interest rates in the U.S. increased. During 2005, the U.S. yield curve flattened significantly, as short to medium term rates increased significantly while long-term rates showed a small decline. The benchmark 90-day treasury rose from 2.22% to 4.08% and the 5-year treasury rose from 3.61% to 4.35%, while the 30-year treasury fell from 4.83% to 4.54% . Interest rates declined in the U.K., where the yield on the benchmark 5-year Gilt fell from 4.49% to 4.17%, however, in the Euro-zone, the yield on the benchmark 5-year German Bund rose slightly from 3.03% to 3.07% .
The Company’s profitability in any given period is based upon its premium and investment revenues as noted above, less net losses incurred and expenses. Net losses incurred are based upon claims paid and changes to unpaid loss reserves. Unpaid loss reserves are estimated by the Company and include both reported loss reserves and reserves for losses incurred but not reported. The Company’s results for 2005 were significantly impacted by the unprecedented insured hurricane losses during the 2005 Atlantic hurricane season, the charge related to the conclusion of the independent actuarial process with Winterthur Swiss Insurance Company and adverse development of prior year loss reserves in both insurance professional lines and reinsurance casualty lines. The Company’s results for 2004 were also significantly impacted by the catastrophe activity in the year, which resulted in $591.2 million in estimated net loss and loss expenses, combined with adverse prior year development in certain lines of the Company’s insurance segment. For a further discussion of these events see “Results of Operations” below.
One way that the Company evaluates the performance of its insurance and reinsurance general operations is the underwriting profit or loss. The Company does not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned and fee income, less net losses incurred and expenses related to the underwriting activities. As noted above, the Company’s underwriting profit and loss for the last three years have been negatively impacted by net losses incurred from catastrophic losses, the results of the independent actuarial process with Winterthur Swiss Insurance Company and adverse development of prior year loss reserves. Partially offsetting this has been the addition of certain new business lines, the increase in premium rates in 2003 and favorable underwriting terms and conditions. Any changes to loss reserves affect the calculation of underwriting profit or loss but most often do not directly affect the Company’s cash flow in the same period. See further discussion below. Barring any unusual catastrophic loss events, the Company expects to produce an underwriting profit in 2006.
The combined ratio for general operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s general insurance and reinsurance operations. A combined ratio of less than 100% indicates an underwriting profit and over 100% indicates an underwriting loss. The Company’s combined ratio for the last three years have been negatively impacted by the factors affecting the underwriting profit (loss), noted above.
Net investment income from its general operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed income securities. Net investment income is primarily affected both by the size of the portfolio and the level of market interest rates. In 2005, the U.S. yield curve flattened significantly with U.S. short to medium term interest rates increasing markedly while long term rates showed a small decline. U.K. rates declined, while in the Euro-zone short term rates rose while medium to long term rates declined. In 2004, U.S. interest rates increased moderately while interest rates in the U.K. and Euro-zone declined. The size of the portfolio is also impacted by cash flow generated from operations and financing, which has been positive during the last three years and which the Company currently expects to be positive in 2006.
To address rating agency requirements regarding the differential between the triple-A ratings of the Company’s financial guaranty companies and their affiliated companies, management is currently exploring a number of strategies that would provide greater independence and stability to XLCA’s and XLFA’s ratings. Examples of actions identified by the rating agencies are, among other things, the inclusion of additional independent directors to the boards of directors of the Company’s financial guaranty companies; adding some level of outside high-quality ownership with voting and/or veto rights; and securing a resolution from each of the boards of directors of the Company’s financial guaranty companies that clarifies our expectations regarding cash payments from the financial guaranty companies. S&P has stated that one or more of these actions will need to be taken by mid-year 2006.
In the normal course of business, the Company evaluates its capital needs to support the volume of business written in order to maintain its claims paying and financial strength ratings. In response to the unprecedented insured hurricane losses during the 2005 Atlantic hurricane season, the loss related to the conclusion of the independent actuarial process with WSIC, rising capital requirements for the property catastrophe business from rating agencies and the currently anticipated growth in business to be written in 2006, the Company raised $3.2 billion in capital through the issuance of a combination of ordinary shares and equity security units. In addition, the Company has implemented several key business initiatives with ratings and capital management implications.
Management continues to reduce the Company’s net catastrophe exposed risks. In the Insurance segment, management continues to reduce exposure to accounts that have the potential for significant volatility under wors-
The impact of the unvaforable result of the independent actuarial process with Winterthur Swiss Insurance Company;
1. Significant large catastrophe activity (Hurricanes Katrina, Rita and other natural catastrophes)
During the third and fourth quarters of 2005, there was an unprecedented number of natural catastrophes. In August 2005, Hurricane Katrina, a Category 4 storm, hit the Gulf Coast of the United States and is estimated to have caused the largest ever insured loss from a natural disaster in the property and casualty insurance industry. In September 2005, Hurricane Rita, a Category 3 storm, hit the Gulf Coast on the United States and caused considerable damage, although Rita was less severe than Katrina. In October 2005, Hurricane Wilma hit South Florida after causing significant damage in Mexico and Cuba. In addition, there were several other natural loss events in the third and fourth quarter 2005, including hurricanes Dennis, Emily and Ophelia, the European and Mumbai Floods and Typhoon Mawar (collectively, the “Other Cats”). Collectively, Hurricanes Katrina, Rita, Wilma, and these Other Cats have had a substantial impact on the Company’s results of operations and financial condition.
As a result of the substantial impact the Hurricanes Katrina, Rita, Wilma and the Other Cats have had on the results of the Company for the year ended December 31, 2005, the Company has estimated losses incurred, net of reinsurance recoveries, of $1.27 billion, $357.9 million and $247.1 million and $96.0 million, respectively, based on preliminary reports and estimates of such loss and damage. The Company has performed an analysis of contracts it believes are exposed to these catastrophes and, together with other preliminary information received from insureds and cedents and industry models, has determined its best estimates at this time for the expected ultimate loss. Actual losses may vary materially from this estimate based on a number of factors, including receipt of additional information from insureds or brokers, the attribution of losses to coverages and/or layers that had not previously been considered as exposed and inflation in repair costs due to additional demand for labor and materials. In addition, the loss estimate includes a high level of uncertainty related to, among other things, complex coverage issues associated with Hurricanes Katrina, Rita and Wilma and potential legal developments that may result in ultimate losses not being known for a considerable period of time. Therefore, losses may ultimately be materially greater or lesser than the current estimate and accordingly impact future financial results. Losses in connection with these events were incurred almost equally from the Company’s Insurance and Reinsurance segments.
* Other natural Catastrophes include European and Mumbai floods, Hurricanes Dennis, Emily and Ophelia and Typhoon Mawar.
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.
The remainder of the strengthening in the casualty and professional lines reserves was driven by a small number of increases in reported claims in the other liability and errors and omissions lines of business in the pre-1997 underwriting years as well as recently reported claims in umbrella liability, errors and omissions and directors’ and officers’ lines of business in the 1997-2001 underwriting years. The professional lines claims activity arose largely from a limited number of cedents. This reserve increase was partially offset by favorable development in the 1997- 2001 underwriting years in the medical malpractice business line. Activity in the post-2001 underwriting years relates primarily to certain large individual claims affecting a number of lines, including surety, umbrella liability and errors and omissions.
During 2003, the net adverse prior period loss development related primarily to the Company’s general reinsurance operations and principally to losses on business written in the 1997 through 2001 underwriting years in the Company’s U.S. casualty reinsurance business. In the third quarter of 2003, the Company experienced a significant increase in claims reported that was in excess of the Company’s expected loss development based on historical reporting patterns and recorded an increase to reserves of $184.0 million related to this book of business. As a result of this increase, the Company began a detailed claims audit review of the cedents contributing to this increase and the lines of business affected were primarily directors’ and officers’, errors and omissions, medical malpractice, commercial umbrella and general liability. Upon completion of this claims audit review, the Company increased case and IBNR reserves relating to this book of business a total of $663.0 million in the fourth quarter of 2003. The Company monitors actual against expected reported claims on an ongoing basis. To the extent that actual experience on loss reserves differs significantly for this, or any other line of business, the Company would again expand its normal and ongoing cedent review program accordingly.
Other significant accounting policies are nevertheless important to an understanding of the Company’s Consolidated Financial Statements. Policies such as those related to revenue recognition, financial instruments and
consolidation require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. See Item 8, Note 2 to the Consolidated Financial Statements.
At December 31, 2005 and 2004, the Company’s total gross reserves for unpaid losses and loss expenses were $23.8 billion and $19.8 billion, respectively, of which $10.6 billion and $9.8 billion related to case reserves for reported claims and $13.2 billion and $10.0 billion for IBNR reserves, respectively.
The ratio of IBNR to total reserves has increased in recent years due to the growth of casualty business written over that period. The ratio of IBNR to total reserves is higher for more recent years’ business because these immature years have relatively fewer claims reported and, as a result, a higher proportion of claims reserves are based on experience in respect of incurred but not reported losses. As each prior year of business matures and claims become known, the ratio of IBNR to total reserves will typically decline, all other factors remaining constant. Since the Company has experienced rapid premium volume growth in recent years, the ratio of IBNR to total reserves has increased because the Company’s aggregate exposure has become relatively less mature. Conversely, in a situation of declining premium volume, this ratio will typically decline, all other factors remaining constant. The Company writes insurance and reinsurance business in many different lines. Typically, the ratio of IBNR to total reserves is greater for casualty lines (which are longer-tail in nature) than for property lines due to the policy forms utilized and timing of loss reporting. In recent years, casualty lines have increased as a proportion of the Company’s business when compared to property lines (which are shorter-tail in nature).
The single point reserve estimate is generally management’s best estimate, which the Company considers to be one that has an equal likelihood of developing a redundancy or deficiency as the loss experience matures, and this amount is recorded. The Company’s actuaries utilize one set of assumptions in determining its single point estimate, which includes loss development factors, loss ratios, reported claim frequency and severity. These reviews and documentation are completed in accordance with professional actuarial standards appropriate to the jurisdictions where the business is written. The selected assumptions reflect the actuary’s judgment based on historical data and experience combined with information concerning current underwriting, economic, judicial, regulatory and other influences on ultimate claim settlements.
With the exception of the adverse development associated with the unfavorable conclusion of the independent actuarial process, actual development of recorded reserves as of December 31, 2004 during 2005 was within the estimated reserve range.
As shown in the table above and as previously noted, the Company developed a methodology for calculating reserve ranges around its single point reserve estimates for all its lines of business. Similar to VAR (Value At Risk) models commonly used to evaluate risk, the Company modeled a statistical distribution of potential reserve outcomes over a one year run-off period. The Company used the modeled statistical distribution to calculate an 80% confidence interval for the potential reserve outcomes over this one year run-off period. The high and low end points of the ranges set forth in the above table are such that there is a 10% modeled probability that the reserve will develop higher than the high point and a 10% modeled probability that the reserve will develop lower than the low point.
Reserve volatility was analyzed for each line of business within each of the Reinsurance and Insurance segments’ general operations using the Company’s historical data supplemented by industry data. These ranges were then aggregated to the lines of business shown above taking into account correlation between lines of business based on a study of the Company’s historical data supplemented by industry data. The practical result of the correlation approach to aggregation is that the ranges by line of business disclosed above, are narrower than the sum of the ranges of the individual lines of business. Similarly, the range for the Company’s total reserves in the aggregate, is narrower than the sum of the ranges for the lines of business disclosed above.
The Company is not aware of any generally accepted model to perform the reserve range analysis described above and other models may also be employed to develop ranges.
Certain aspects of the Company’s casualty operations complicate the actuarial process for establishing reserves. Certain casualty business written by the Company’s insurance operations is high layer excess casualty business,
High layer excess casualty insurance claims typically involve claims relating to (i) a “shock loss” such as an explosion or transportation accident causing severe damage to persons and/or property over a short period of time, (ii) a “non-shock” loss where a large number of claimants are exposed to injurious conditions over a longer period of time, such as exposure to chemicals or pharmaceuticals or (iii) a professional liability loss such as a medical malpractice claim. In each case, these claims are ultimately settled following extensive negotiations and legal proceedings. This process can typically take 5 to 15 years following the date of loss.
Except for certain workers’ compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% at December 31, 2005 and 2004. For further discussion see the Consolidated Financial Statements.
The Company is aware of the SEC’s recent review of the loss reserving practices in 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”) and FASB Statement of Financial Accounting Standards No. 97 “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“FAS 97”), 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 FAS 97. It is the Company’s understanding that the SEC has requested that the FASB review this matter and provide guidance for the accounting of financial guaranty insurance contracts. The Company will continue its loss reserving methodology as noted in Note 2 (k) to the Consolidated Financial
Statements until further guidance is provided by the SEC or the FASB. The Company had net reserves for financial guaranty insurance contracts of $173.7 million and $146.3 million at December 31, 2005 and 2004, respectively.
The recognition of unpaid losses and loss expenses recoverable requires two key judgments. The first judgment involves the Company’s estimation of the amount of gross IBNR to be ceded to reinsurers. Ceded IBNR is generally developed as part of the Company’s loss reserving process and consequently, its estimation is subject to similar risks and uncertainties as the estimation of gross IBNR (see “Critical Accounting Policies and Estimates - Unpaid losses and loss expenses and unpaid loss and loss expense recoverable”). The second judgment involves the Company’s estimate of the amount of the reinsurance recoverable balance that the Company will ultimately be unable to recover from related reinsurers due to insolvency, contractual dispute, or for other reasons. Amounts estimated to be uncollectible are reflected in a bad debt provision that reduces the reinsurance recoverable balance and shareholders’ equity. Changes in the bad debt provision are reflected in net income. See “Financial Condition and Liquidity” and Item 8, Note 10 to the Consolidated Financial Statements for further information.
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the issue of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency exists. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e., mortality and interest). Provisions for adverse deviation are designed to cover reasonable deviations from the best estimate outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such review would produce reserves in excess of those currently held then lock-in assumptions will be revised and a loss recognized. During the years ended December 31, 2005, 2004 and 2003, there were no adjustments to the locked-in assumptions for any of these contracts.
As stated above, the future policy benefit reserves include provisions for adverse deviation in excess of best estimate assumptions that amounted to approximately $310 million and $145 million at December 31, 2005 and 2004, 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 $18 million if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions.
The liabilities relate to in-force blocks of business, which are comprised of underlying insurance policies that provide mainly lump sum benefits if the policyholder dies. The liabilities are therefore driven by the rates of mortality,
The fair value of weather and energy derivatives is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair value is estimated using available market data and internal pricing models using consistent statistical methodologies. Estimating fair value of instruments that do not
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary. These include subsequent significant changes in general economic conditions as well as specific business conditions affecting particular issuers, subjective assessment of issue-specific factors (seniority of claims, collateral value, etc.), future financial market effects, stability of foreign governments and economies, future rating agency actions and significant disclosure of accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, significant assumptions and management judgment are involved in determining if the decline is other than temporary. If management determines that a decline in fair value is temporary, then a security’s value is not written down at that time. However, there are potential effects upon the Company’s future earnings and financial position should management later conclude that some of the current declines in the fair value of the investments are other than temporary declines. See “- Investment Activities - Unrealized losses on investments” for further information.
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 $238.1 million and $230.6 million against which a valuation allowance of $154.5 million and $68.6 million at December 31, 2005 and 2004, respectively, has been established. The Company has capitalized realized and unrealized capital losses of $19.7 million and $7.7 million, respectively, against which a valuation allowance of $23.7 million at December 31, 2005 has been 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 23 to the Consolidated Financial Statements.
The Company utilizes variable interest entities both directly and indirectly in the ordinary course of business. The Company must assess consolidation of variable interest entities based on whether the Company is the primary beneficiary of the entity. The company that absorbs a majority of the expected losses or residual rewards of the entity is deemed to be the primary beneficiary and is therefore required to consolidate the entity. The determination of expected losses and expected residual returns requires the Company to estimate the expected cash flows of the entities
and measure the expected variability of these cash flows. The use of different assumptions to determine the expected cash flows and variability could affect the Company’s determination of the primary beneficiary. The assumptions used to determine the expected cash flows depend on the type of structure and the nature of the Company’s variable interest. The Company has made assumptions primarily regarding default rates, the timing of defaults and recovery rates to estimate these expected cash flows of the variable interest entities that it utilizes.
Written premiums on excess of loss contracts are earned in accordance with the loss occurring period defined within the treaty, normally 12 months following inception of the contract. Written premiums on proportional contracts are earned over the risk periods of the underlying policies issued and renewed, normally 24 months. For both excess of loss and proportional contracts, the earned premium is recognized ratably over the earning period, namely 12 - 24 months. The portion of the premium related to the unexpired portion of the policy at the end of any reporting period is reflected in unearned premiums.
Political risk insurance business units now report to executive management of the Financial Products and Services segment and, as such, future earnings from this business will no longer be reported in the Insurance segment but included with financial operations.
All operations of business units within the Financial Products and Services segment, including guaranteed investment contracts and funding agreements, are now reported under financial operations in order to consolidate businesses with similar operating characteristics and risks.
In addition, the Company has changed its presentation of certain credit derivatives and now records premiums received from sales of these derivatives in gross written premiums and establishes unearned premium reserves and loss reserves for its investment grade credit derivative business. Previously, all components of the Company’s consolidated statements of income impact related to credit default swaps had been reported on one line, “Net Realized and Unrealized Gains (Losses) on Derivative Instruments.” Prior periods have been re-presented for consistency in presentation.
Gross and net premiums written decreased by 2.3% and 3.4%, respectively, in the year ended December 31, 2005 compared with the year ended December 31, 2004. These decreases were primarily due to continued competitive pricing across most lines, most notably property. Decreases were partially offset by continued growth in the
Increases in gross and net premiums written in 2004 as compared to 2003 were primarily due to new business in the casualty and professional lines, multi-year contracts written in the year and favorable foreign exchange movements. The most significant growth was due to new business product offerings in the areas of primary casualty, specialty professional and property catastrophe risks. Partially offsetting the growth in gross and net premiums written in 2004 were rate reductions in most property and professional lines as well as growing rate pressures on most casualty lines during 2004.
Net premiums earned increased by 1.2% in 2005 compared with 2004. Growth in net premiums earned is primarily as a result of the earn-out of net premiums written in 2004, including the newer business initiatives mentioned above and increased net retentions. This growth was partially offset by the decreased volume in 2005, noted above, and net $89.1 million ceded reinstatement premiums as a result of the natural catastrophes in 2005.
Fee income and other decreased in 2005 compared to 2004 and increased in 2004 as compared to 2003 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.
Exchange gains are primarily generated by movement in foreign exchange rates applied to loss reserves held in currencies other than the functional currency of the reporting subsidiary. The gain in 2003 was partially reduced by a hedge put in place by the Company in February 2003 to cover part of its exposure to a U.K. sterling reinsurance recoverable balance.
The decreases in the underwriting profit in 2005 as compared with 2004 and the decreases in 2004 as compared with 2003 were also reflective of the combined ratios, as shown below. The following table presents the ratios for the Insurance segment for each of the last three years ended December 31:
The loss and loss expense ratio for the Insurance segment for the year ended December 31, 2004 increased compared with the year ended December 31, 2003 primarily due to net hurricane losses of $298.3 million in the property and marine lines, combined with prior year reserve strengthening as discussed below, and losses and loss
Net premiums earned in the year ended December 31, 2005 decreased 5.5% compared to the year ended December 31, 2004, due primarily to the earn-out of the impact of rate pressures seen in gross premiums.
Net premiums earned in 2004 increased 18.4% as compared to 2003 due primarily to the earning of net written premium growth over the last several years, most notably in casualty and professional lines of business. Net premiums earned for casualty and professional reinsurance lines combined were $1.2 billion in 2004 as compared to $971.2 million in 2003.
The decrease in the loss and loss expense ratio for the year ended December 31, 2004 compared to the same period in 2003 was primarily due to the fact that 2003 included significant adverse prior period development related to the Company’s North American casualty business. See further discussion below. The Reinsurance segment experienced losses in 2004 resulting from Hurricanes Charley, Frances, Ivan and Jeanne, from which the segment incurred a combined $268.3 million of net losses and loss expenses. In addition, the segment incurred net losses and loss expenses of $24.6 million as a result of the earthquake and tsunami in South Asia. These large catastrophe losses contributed 10.0% to the segment loss ratio for the year ended December 31, 2004. Catastrophe losses were partially offset by lower than expected incurred loss development in the year relating to shorter tail lines prior underwriting years and price improvements on earned premiums from prior periods.
The following tables present the adverse prior year development of the Company’s gross and net loss and loss expense reserves for its reinsurance general operations:
The remainder of the strengthening in the casualty and professional lines reserves was driven by a small number of increases in reported claims in the other liability and errors and omissions lines of business in the pre-1997 underwriting years as well as recently reported claims in umbrella liability, errors and omissions and directors’ and officers’ lines of business in the 1997-2001 underwriting years. The professional lines claims activity arises largely from a limited number of cedents. This reserve increase was partially offset by favorable development in the 1997- 2001 underwriting years in the medical malpractice business line. Activity in the post-2001 underwriting years relates primarily to certain large individual claims affecting a number of lines, including surety, umbrella liability and errors and omissions.
During 2004, net prior year reserves across the Reinsurance segment developed favorably by $24 million. Releases of $144 million in the property, aviation, marine and other lines of business were partially offset by strengthening of casualty and accident and health reserves amounting to approximately $122 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 $77 million and related most significantly to professional liability reserves 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 utilizes industry standard asbestos and environmental claims models to estimate its ultimate liability for these exposures.
The Company reviews its actual reported loss experience for asbestos and environmental claims for its 1985 and prior exposures annually. The actual loss experience was consistent with assumptions established and, therefore, there was no adverse prior year development of the Company’s asbestos and environmental reserves in 2004 or 2005. The reserves for these exposures represented less than 1% of the Company’s total unpaid loss and loss expense reserves at December 31, 2005.
The decrease in the underwriting expense ratio in the year ended December 31, 2005, as compared with the year ended December 31, 2004, was due to a decrease in both the acquisition expense ratio and operating expense
ratio to 21.7% and 5.6%, respectively, as compared to 22.1% and 6.5%, respectively, for the year ended 2004. The decrease in the acquisition expense ratio was mainly due to decreased profit commissions, which resulted from the 2005 hurricane activity. The operating expense ratio decrease primarily reflects severance costs incurred during 2004 for reduction of staff as well as productivity expense management initiatives in 2005 and adjustments to certain 2005 compensation costs.
The decrease in the underwriting expense ratio for the year ended December 31, 2004 as compared with 2003 was primarily due to a decrease in acquisition cost ratio driven by reduced profit commissions as a result of the year’s catastrophic losses. This decrease was partially offset by an increase in the operating expense ratio resulting from additional allocations of corporate expenses as well as the adverse impact of foreign exchange.
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 in those operations’ unpaid losses in non-U.S. dollar currencies. Exchange gains in 2004 and 2003 were mainly attributable to a decline in the value of the U.S. dollar against U.K. sterling and the Euro in Bermuda-based operations that write business globally.
Net investment income has increased reflecting the increase in life business invested assets primarily arising from new large annuity contracts written since 2004. Net investment income is included in the calculation of net income from life and annuity operations as it relates to income earned on portfolios of separately identified and managed life investment assets and other allocated assets. The accretion of the related future policy benefit reserves is included in claims and policy benefits.
Increases in gross and net premiums written of 9.5% 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 following table provides a line of business breakdown of the Financial Products and Services segment’s net premiums earned:
The increase in net premiums earned in 2004, as compared to the prior year, was primarily due to growth in the financial guaranty in force book of business, in conjunction with the acceleration of $23.3 million in premium earnings on the insured project financing discussed above (for further discussion see “Net losses and loss expenses” below). This increase was partially offset by the impact on earned premiums in 2003 related to the refunding of certain insured financings and certain short term contract enhancements.
Net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year reserves for net losses and loss expenses. Net losses and loss expenses during 2005 decreased by 7.5%, as compared to 2004. This decrease primarily resulted from lower incurred losses in the Company’s financial guaranty business of approximately $65.8 million due primarily to the absence of significant individual losses as compared to the prior year, as well as favorable development associated with the Company’s unallocated loss reserves, partially offset by an increase in loss reserves in our structured property and casualty business of approximately $50.4 million that primarily resulted from a limit loss incurred under a contract related to Hurricane Katrina.
Net losses and loss expenses in 2004 increased by 14.1% compared to 2003. The increase was primarily the result of a provision for losses in 2004 of approximately $41.7 million relating to the subordinate layer of an insured
Net investment income related to the financial guaranty business increased by 76.0% in 2005, as compared to 2004, due primarily to higher average invested assets resulting from net cash inflows from operations and a $125.0 million capital infusion during the fourth quarter of 2004. In addition, $16.3 million in investment income (including a special one-time dividend paid in 2005 of $9.9 million) relates to the Company’s investment in Financial Security Assurance International Ltd. (“FSAI”). The special dividend was paid in connection with the redemption of the Company’s investment in FSAI during December of 2005. Prior to October 1, 2004, this investment in FSAI was accounted for under the equity method and reported the associated results thereof in “Net income from financial and investment affiliates”. Effective October 1, 2004, the Company changed the accounting for its investment in FSAI from the equity method to FSAB 115, Accounting for Certain Investments in Debt and Equity Securities to conform to the requirements of EITF 02-14 Whether an Investor Should Apply the Equity Method of Accounting to Investments Other Than Common Stock (“EITF 02-14”). Accordingly, beginning October 1, 2004 the only earnings recognized by the Company on its investment in FSAI were dividends that were reported in investment income.
Net investment income related to the financial guaranty business increased by 75.2% in 2004, as compared to 2003, due primarily to higher average invested assets resulting from net cash inflows from operations and a $100.0 million capital infusion to this business in the fourth quarter of 2003.
Net investment income related to structured products increased by 80.2% in 2005, as compared to 2004, primarily as a result of a significant increase in average funding agreement and guaranteed investment contract deposits from $2.8 billion in 2004 to $4.9 billion in 2005. Similarly, net investment income related to structured products increased 55.7% in 2004, as compared to 2003, due to an increase in average funding agreement and guaranteed investment contract deposits from $1.1 billion in 2003 to $2.8 billion in 2004.
Interest expense on structured products relates to deposit liabilities associated with funding agreements, guaranteed investment contracts and certain structured property and casualty contracts. The increase in interest expense during 2005, as compared to 2004, related primarily to the increase in the average funding agreement and guaranteed investment contract deposits in 2005 discussed above, partially offset by reduced interest expense on certain structured property and casualty contracts resulting from a change in the timing of estimated future cash outflows from such contracts during 2005.
Net income from financial affiliates includes earnings on the Company’s investment in Primus Guaranty, Ltd (“Primus”) and certain of the Company’s investment affiliates, which are accounted for under the equity method. The decrease in such earnings in 2005, as compared to 2004, was due primarily to a decrease in earnings from Primus, as
Minority interest in 2005 is consistent with 2004. The decrease in minority interest in 2004, as compared to 2003, reflects the fact that the minority interest holder’s return on investment is contractually capped. The minority interest relates to an equity position in XL Financial Assurance Ltd., which is held by a third party.
The following table illustrates the change in net investment income from general operations, net income from investment affiliates, net realized gains and losses on investments and net realized and unrealized gains and losses on investment derivatives for each of the three years ended December 31:
2005, (ii) cash flow of $2.0 billion from spread product transactions and (iii) cash flow from operations of $4.2 billion. The annualized effective yield of the total investment portfolio (excluding non-recurring items) was 4.1% for 2005 as compared to 3.8% for 2004, a 0.3% increase. The increase in the effective yield of the total investment portfolio was primarily due to general interest rate increases in the U.S.
Portfolio returns are calculated by dividing the sum of the net investment income or net income from investment affiliates, realized gains (losses) and unrealized gains (losses) by the average market value of each portfolio. Non U.S. dollar fixed income performance is measured in either the underlying currency or in U.S. dollars.
included $53.2 million of provisions for declines in fair value considered to be other than temporary. In the U.S., the general level of corporate defaults was stable. For example, Moody’s Investors Service, Inc. (“Moody’s”) reported that 31 issuers defaulted in 2005 compared with 34 issuers in 2004 and 77 issuers in 2003. The Company’s exposure to these defaults was limited in both 2005 and 2004, compared to 2003, resulting in a reduction in the write-down for other than temporary declines. As a percentage of the total fixed income portfolio, the write-down for other than temporary declines was 0.1% in 2005 as compared to a negligible amount in 2004 and 0.6% in 2003.
In 2003, net realized gains on investments were $120.2 million, which included $344.8 million of gross realized losses on fixed income and $162.5 million of gross realized losses on equity securities. Gross realized losses in 2003 included $130.7 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, 2004, 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, 2005, the Company realized losses of $250.8 million and $54.1 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. During the year ended December 31, 2004, the Company realized losses of $18.9 million and $3.3 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).
The information shown below about the unrealized losses on the Company’s investments at December 31, 2005 and 2004, concerns the potential effect upon future earnings and financial position should management later conclude that some of the current declines in the fair value of these investments are other than temporary declines.
Of the $119.7 million gross unrealized investment losses on the fixed income and short term investments portfolio at December 31, 2004, approximately $45.2 million related to corporate fixed income securities. Within the corporate fixed income securities, approximately 43.8% of the losses were in the financial sector, 11.0% in the communications sector, 8.4% in the utilities sector, 8.2% in the consumer, non-cyclical sector and 7.1% in the consumer cyclical sector. No other sector was greater than 5%. The largest individual unrealized loss in the fixed income portfolio was $4.9 million. Approximately 20 equity securities held by the Company with total unrealized losses of approximately $2.0 million at December 31, 2004, were in a continual unrealized loss position for at least 12 months. The largest individual unrealized loss in the equity portfolio was $1.0 million.
Net income from operating affiliates in 2003 included an other than temporary decline of $40.9 million in the value of the Company’s investment in Annuity and Life Reinsurance Company. The investment was written down to its fair value of $2.2 million at March 31, 2003. See Item 8, Note 7 to the Consolidated Financial Statements for further discussion.
Amortization of intangible assets decreased in 2005 as a result of certain intangible assets that were fully amortized during the year. Amortization of intangible assets increased in 2004 as compared to 2003 due primarily to the acquisition of a book of business related to XL Re Europe at the end of 2003.
In 2004, interest expense has increased primarily as a result of the additional interest related to the senior notes issued in March, August and November of 2004, partially offset by the reduced interest as a result of the redemption of the Liquid Yield Option Notes and Zero Coupon Convertible Debentures during that year.
The table below represents a reconciliation of the Company’s general and financial operations unpaid losses and loss expenses for the year ended December 31, 2005:
Bad debt reserve on unpaid losses and loss expenses recoverable and
Included in unpaid loss and loss expenses recoverable at December 31, 2004, was an unsecured reinsurance recoverable from WSIC of $1.45 billion, related to certain contractual arrangements in the SPA entered into in connection with the Company’s acquisition of Winterthur International in July 2001. This balance was settled in 2005 for $575 million, resulting in a loss of $808.9 million, net of interest received.
Under two retrocession agreements the Company has reinsurance protection on the reinsurance recoverables with respect to the Seasoned Net Reserves Amount determined as of June 30, 2004, to the extent that the Company does not receive payment of such amounts from applicable reinsurers with one agreement providing a limit of $1.3 billion for the insurance written in the period to June 30, 2001, and the other agreement providing a limit of $1.3 billion for the insurance written in the period to December 31, 2000.
Approximately 76% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (excluding collateral held) outstanding at December 31, 2005, were due from reinsurers rated “A” or better by S&P. The following is an analysis of the total recoverable and reinsurance balances receivable at December 31, 2005, by reinsurers owing more than 3% of such total:
The following table sets forth the ratings profile of the reinsurers that support the unpaid loss and loss expense recoverable and reinsurance balances receivable net of security noted above.
loss expenses. Therefore, the amount of claims paid in any one year is not necessarily related to the amount of net losses incurred, as reported in the consolidated statement of income.
Generally, positive cash flow from operations and financing activities is invested in the Company’s portfolio, including affiliates or acquisition of subsidiaries. Investing activities in 2005, were primarily related to the renewal purchase and sale of portfolio investments. In 2004, in addition to purchases and sales of the Company’s total investment portfolio, the Company sold its interests in Admiral Group Ltd and Pareto Partners L.P. and its affiliated companies for $66.7 million and $45.1 million, respectively.
In September 2003, the Company exercised its option and settled the related Euro liability to purchase the remaining 33% ownership of Le Mans Ré, now known as XL Re Europe, for approximately $161 million.
See Item 8, Note 5(a) to the Consolidated Financial Statements for further information.
Cash flows related to financing activities include the payment of dividends, share related transactions, the issue or repayment of debt and deposit liability transactions. In 2005 and 2004, the Company received $2.0 billion and $1.5 billion of net cash relating to new deposit liability contracts. In 2005, dividends paid were $276.7 million for ordinary shares and $40.3 million for preferred shares.
Sufficient capital to enable its underwriting subsidiaries to meet the capital adequacy tests performed by statutory agencies in the U.S., the U.K., and other key markets.
Letters of credit and other forms of collateral that are required by the Company’s non-U.S. operating companies that are “non-admitted” under U.S. state insurance regulations. The Company also uses letters of credit to support its operations at Lloyd’s.
The Company’s principal credit facilities are multi-year transactions with maturities in 2007 and 2010, however, the Company has other credit facilities that will expire in 2006. The following risks are associated with the Company’s requirement to renew these facilities during 2006:
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 independent actuarial process with WSIC. The net proceeds from this issuance were $2.4 billion. See Item 8, Note 19, to the Consolidated Financial Statements.
Senior Unsecured Notes of approximately $3.4 billion. These notes require the Company to pay a fixed rate of interest during their lives. At December 31, 2005, there were six outstanding issues of senior unsecured notes:
$825 million of senior notes due May 2009, with a fixed coupon of 2.53%. These securities are a component of 6.50% Equity Security Units (the “6.50% Units”) that are publicly traded. In addition to the coupon paid on the senior notes, contract adjustment payments of 3.97% per annum are paid on forward purchase contracts for the Company’s common shares for a total distribution of 6.50% per annum. The purchase contracts mature in 2007, and the senior notes mature in 2009. In May 2007, the senior notes will be remarketed whereby the interest rate will be reset in order to generate sufficient remarketing proceeds to satisfy the 6.50% Unit holders’ obligations under the purchase contract.
$745 million of senior notes due February 2011 with a fixed coupon of 5.25%. These securities are a component of 7.00% Equity Security Units (the “7.00% Units”) that are publicly traded. In addition to the coupon paid on the senior notes, contract adjustment payments of 1.75% per annum are paid on forward purchase contracts for the Company’s common shares for a total distribution of 7.00% per annum. The purchase contracts mature in 2009, and the senior notes mature in 2011. In February 2009, the senior notes will be remarketed whereby the interest rate will be reset in order to generate sufficient remarketing proceeds to satisfy the 7.00% Unit holders’ obligations under the purchase contract.
“Commitment” and “In Use” data represent December 31, 2005 accreted values. “Payments Due by Period” data represent ultimate redemption values.
On December 10, 2004, 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. There is no limit to the number of times that XLFA may exercise the put option, redeem the Series B Preferred Shares from the Asset Trust and exercise the put option again. 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 premium payable by XLFA is the sum of certain trustee and investment managers expenses, the distribution of income paid to holders of the pass-through trust securities, less the investment yield on the eligible assets purchased using the proceeds originally raised from the issuance of the pass-through securities.
At December 31, 2005, the Company had eight letter of credit facilities in place with total availability of $5.5 billion, of which $3.5 billion was utilized.
In June 2005, the Company replaced its $1.0 billion 364-day credit and letter of credit facility with a $2.35 billion facility with a tenor of 5 years. Of the aggregate amount of $2.35 billion, $1.0 billion is available as revolving credit and up to $2.25 billion is available in the form of letters of credit, with the combined total not to exceed $2.35 billion. As at December 31, 2005, approximately $2.1 billion of the 5-year facility was in use in the form of letters of credit.
In addition to the letter of credit facilities described above, the Company has the following facility:
Documents”), contain cross default provisions to each other and the Company’s Debt Documents contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of the Company’s insurance and reinsurance operating subsidiaries (other than its AAA financial guaranty companies) and the level of secured indebtedness in the future. In addition, generally each of the Company’s Debt Documents provide for an event of default in the event of a change of control of the Company or some events involving bankruptcy, insolvency or reorganization of the Company. The Company’s credit facilities and the 6.58% Guaranteed Senior Notes also contain minimum consolidated net worth covenants.
Deposit liabilities on the Company’s Consolidated Balance Sheet at December 31, 2005 amounted to $8,240,987. The difference from the amount included above relates to the discount on payments due in the future. The payment related to these liabilities varies primarily based on interest rates. The ultimate payments associated with these liabilities could differ from the Company’s estimate. See Item 8, Note 11 to the Consolidated Financial Statements for further information.
(2) The unpaid loss and loss expenses amounted to $23,767,672 on the Company’s Consolidated Balance Sheet at December 31, 2005. 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.
The Company provides various forms of credit enhancement including financial guaranty insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk-based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. In synthetic transactions, the Company guarantees payment obligations of counterparties including special purpose vehicles under credit derivatives referencing asset portfolios. The Company invests in collateralized debt obligations (“CDOs”), and other investment vehicles that are issued through variable interest entities as part of the Company’s risk asset portfolio.
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.
Equity securities, at fair value (cost: 2005, $696,858; 2004, $ 778,117)
Proceeds from exercise of stock options and issue of common shares
XL Capital Ltd together with its subsidiaries (the “Company” or “XL”), is a holding company organized under the laws of the Cayman Islands. XL Capital Ltd was incorporated on March 16, 1998, as the successor to EXEL Limited, a Cayman Islands corporation organized in 1986, in connection with EXEL Limited’s merger with Mid Ocean Limited, a Cayman Islands corporation. XL Capital Ltd operated under the name EXEL Limited from completion of the merger until February 1, 1999, when its current name was approved by the requisite vote of the Company’s shareholders. The Company provides insurance and reinsurance coverages and financial products and services to industrial, commercial and professional service firms, insurance companies and other enterprises on a worldwide basis.
Effective January 1, 2002, the Company increased its shareholding in Le Mans Ré from 49% to 67% in order to expand its international reinsurance operations. Due to certain contractual arrangements between the Company and Les Mutuelles du Mans Assurances Group (“MMA”), MMA did not have any economic interest in the earnings of Le Mans Ré with effect from January 1, 2002 and accordingly, no minority interest was recorded from that date. In September 2003, the Company purchased the remaining 33% and Le Mans Ré was renamed “XL Re Europe”. XL Re Europe underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business, together with a selective portfolio of life reinsurance business. See Note 5 for additional information.
On July 25, 2001, the Company acquired certain Winterthur International insurance operations (the “Winterthur Business”) to extend its predominantly North American-based large corporate business globally. Effective July 1, 2001, the Company’s results include the Winterthur Business. See Note 5 for additional information. In 2003, the Company re-branded “XL Winterthur International” to “XL Insurance Global Risk”.
Acquisition costs, which vary with and are directly related to the acquisition of policies, consist primarily of commissions paid to brokers and cedents 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.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information, market conditions generally and assessing value relative to other comparable securities.
The Company conducts activities in three main types of instruments: credit derivatives, weather and energy derivatives and investment related derivatives.
The determination of whether an entity is classified as an affiliate for GAAP accounting purposes may be different from the determination of whether such entity would constitute an affiliate for any other purposes, including regulatory purposes. The income from affiliates is shown separately between net income from operating affiliates and net income from investment affiliates. Any decline in value of an affiliate investment considered by management to be other than temporary is charged to income in the period that it is determined.
Contracts entered into by the Company with cedents which are not deemed to transfer significant underwriting and/or timing risk are accounted for as deposits, whereby liabilities are initially recorded at an amount equal to the assets received. The Company uses a portfolio rate of return of equivalent duration to the liabilities in determining risk transfer. An initial accretion rate is established based on actuarial estimates whereby the deposit liability is increased to the estimated amount payable over the term of the contract.
The Company accounts for stock compensation plans in accordance with the fair value recognition provisions of FAS 123 “Accounting for Stock-Based Compensation”. This method was adopted as of January 1, 2003 using the prospective method allowed under FAS 148, “Accounting for Stock-Based Compensation - Transition and
Fair values of investments and derivatives are based on published market values if available, estimates of fair values of similar issues or estimates of fair values determined by the Company. See Notes 2, 6, 14 and 15 for further information on other financial instruments.
Statement of Position (“SOP”) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (“SOP 03-3”), addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. SOP 03-3 limits the yield that may be accreted (accretable yield) to the excess of the investor’s estimate of undiscounted expected principal, interest and other cash flows (cash flows expected at acquisition to be collected) over the investor’s initial investment in the debt security. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004. The adoption of SOP 03-3 did not have a material effect on the Company’s financial condition or results of operations.
In December 2004, the FASB issued Statement No. 123 (Revised), Share-Based Payment, which requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. This statement is effective as of January 1, 2006. The Company adopted the fair value-based method of accounting for share-based payments effective January 1, 2003 using the prospective method described in FAS 148. FAS 123 (Revised) must be applied not only to new awards but to previously granted awards that are not fully vested on the effective date. However, had we adopted FAS 123 (Revised) in prior periods, the impact of that standard would have approximated the impact of FAS 123 as described in the disclosure of pro forma net income and earnings per share in Note 2 (o) - Stock Plans to our consolidated financial statements. Statement 123 (Revised) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement reduces net operating cash flows and increased net financing cash flows in periods after adoption.
In March 2005, the FASB issued FASB Staff Position (“FSP”) FIN 46(R)-5, Implicit Variable Interests Under FASB Interpretation No. 46(R) (“FSP FIN 46(R)-5”), which requires an enterprise to consider whether it holds an implicit variable interest in a Variable Interest Entity (“VIE”) and what effect this may have on the calculation of expected losses and residual returns of the VIE and the determination of which party, if any, is considered the primary beneficiary of the VIE. FSP FIN 46(R)-5 was effective for the first reporting period beginning after March 3, 2005 and did not have a material impact on the Company’s financial condition or results of operations.
In May 2005, the FASB issued FAS No. 154, Accounting Changes and Error Corrections (“FAS 154”), which changes the requirements for the accounting for and reporting of changes in accounting principles. FAS 154 applies to all voluntary changes in accounting principles and changes the requirements for accounting for, and reporting of, changes in accounting principles. FAS 154 will be effective for fiscal years beginning after December 2005.
The Company is aware of the SEC’s recent 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. 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 $173.7 million and $145.3 million at December 31, 2005 and 2004, respectively.
The Company operates through three business segments: Insurance, Reinsurance and Financial Products and Services. These business segments were determined in accordance with Statement of Financial Accounting Standards (“FAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information.”
Political risk insurance business units now report to executive management of the Financial Products and Services segment and, as such, future earnings from this business are no longer reported in the Insurance segment but included with financial operations.
General insurance business written includes risk management and specialty lines. Risk management products comprise global property and casualty insurance programs for large multinational companies, including umbrella liability, products recall, U.S. workers’ compensation, property catastrophe, and primary property and liability coverages. Specialty lines products include the following lines of business: professional liability, environmental liability, political risk insurance, aviation and satellite, marine and offshore energy insurance, equine and other insurance coverages including program business.
This includes net realized gains on investments of $241.9 million and net realized and unrealized losses on investment derivatives of $(16.6) million.
The following is an analysis of results by segment together with a reconciliation to net income or loss:
This includes net realized gains on investments of $120.2 million and net realized and unrealized losses on investment derivatives of $1.9 million.
(1) Other, includes political risk, surety, bonding, warranty and other lines.
(1) Other, includes workers compensation, political risk, surety, bonding, warranty and other lines.
The following table shows an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2005, 2004 and 2003:
(1) Amortization of intangible assets includes $2.7 million related to an acquired block of business expensed through acquisition costs
The cost of the acquisition for the increase in ownership from 49% to 67% in 2002 was approximately $188.5 million. Goodwill arising from the acquisition was approximately $52.6 million. The Company recognized goodwill in excess of the fair value of XL Re Europe’s net assets to increase its European franchise for its reinsurance operations. Cash paid, net of cash acquired, amounted to $45.5 million during the year ended December 31, 2002.
Under the terms of the Sale and Purchase Agreement, as amended, between XL Insurance (Bermuda) Ltd and WSIC, (the “SPA”) WSIC provided the Company with post-closing protection determined as of June 30, 2004 with respect to, among other things, adverse development of reserves and premium Winterthur 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 develops a value of the seasoned net reserves. The actual final seasoned amount is the submission that is closest to the number developed by the Independent Actuary.
As the Company and WSIC were unable to come to an agreement, the Company submitted to WSIC notice to trigger the independent actuarial process as contemplated by the SPA. On February 3, 2005, both the Company and WSIC made submissions for the independent actuarial process. The Company’s submission would have resulted in a net payable to the Company of approximately $1.4 billion in aggregate and WSIC submission would have resulted in a net payable to the Company of $541 million in aggregate.
1. At the time of the Winterthur International acquisition, WSIC provided to the Company a liquidity facility. At the time of the payment of the net reserve seasoned amount on December 12, 2005, the Company exercised its right to repay up to the balances outstanding on this facility by assignment to WSIC of an equal amount of receivables relating to reinsurance recoverables selected by the Company. During December 2005, the Company assigned $265.4 million of receivables to WSIC under this arrangement, although WSIC has disputed the assignment of certain of these receivables.
The Company estimated the total value of intangible assets acquired at $29.8 million, including $14.7 million for insurance licenses and sales force, which have an indefinite life and are not therefore subject to amortization. The remaining $15.1 million relates to the value of business in force, which is estimated to have a finite life of up to nine years and is being amortized over that period.
The total amount of other than temporary declines in value in 2005 related to $47.2 million on fixed income securities and $6.0 million on equity securities.
The total amount of other than temporary declines in value in 2004 related to $4.1 million on fixed income securities, $1.9 million on equity securities and $0.4 million on other investments.
At December 31, 2005 and 2004, approximately $377.4 million and $109.8 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, 2005 and 2004, approximately $386.5 million and $111.8 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, 2005 and 2004, approximately $603.8 million and $463.2 million, respectively, of securities were on deposit with various U.S. state or government insurance departments in order to comply with relevant insurance regulations.
The fair values of securities on loan at December 31, 2005 and 2004 are detailed below.
The Company’s insurance affiliate investments at December 31, 2005 included American Strategic Holdings, with ownership in this entity at 48.5% .
The significant investment management affiliates include Highfields Capital Management LP, a global equity investment firm, MKP Capital Management, a fixed income investment manager, specializing in mortgage-backed securities, FrontPoint Partners LLC, an integrated alternative asset firm, Stanfield Capital Partners, a credit-oriented asset management firm specializing in event-driven strategies and Clo’s, Stanfield Global Strategies, a structured investment vehicle and conduit manager, One Capital Management Partners, an alternative strategy distribution business firm, Banquo Credit Management LLC, a European credit based asset management firm, and Artemis Advisor LLC, a U.S. focused equity firm. 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.
Other investments include investments over which the Company does not have significant influence and whose fair value is generally unquoted. This includes investments in limited partnerships where the Company does not participate in the management of the partnerships, and investments in non-rated collateralized debt/equity instruments. Income from other investments was $55.0 million and $16.2 million for the years ended December 31, 2005 and 2004, respectively. Unrealized gains from these limited partnerships was $7.5 million and $0.2 million as at December 31, 2005 and 2004 respectively. Income on unrated tranches of collateral debt obligations is reflected only to the extent the Company’s principal has been fully recovered. Income on alternative investments included in other investments is realized only on ultimate sale of these investments. The Company had unrealized gains of $19.3 million and $1.2 million, respectively, at December 31, 2005 and 2004, related to these alternative investments.
The Company recorded losses of $0.02 million, $0.4 million and $8.1 million in the years ended December 31, 2005, 2004 and 2003, respectively, due to other than temporary declines in values of these other investments.
Less net losses and loss expenses paid in respect of losses occurring in:
The significant developments in prior year loss reserve year estimates for each the years indicated within each of the Company’s operating segments are discussed below.
During 2004, the Company’s net adverse prior year development of $292 million was affected by increases in reported case reserves for excess professional liability, excess casualty liability and specialty lines. These increases in reported case reserves exceeded the Company’s expected losses based on historical patterns of loss development.
Strengthening of $144 million in professional lines was caused by a few large directors’ and officers’ claims in pre-2002 business, while changes in errors and omissions reserves were caused by large accounting firms and exposure to insurance/reinsurance brokers. For specialty lines, strengthening of $135 million was caused by reported loss increased in discontinued programs business with workers’ compensation exposure environmental related coverages, and Lloyd’s; as well as high severity claims on the surety book.
The Company did not change its methodology or key assumptions used in 2005, 2004 or 2003 to determine ultimate loss reserves for any line of insurance business written.
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 cedent. 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.
The remainder of the strengthening in the casualty and professional lines reserves was driven by a small number of increases in reported claims in the other liability and errors and omissions lines of business in the pre-1997 underwriting years as well as recently reported claims in umbrella liability, errors and omissions and directors and officers lines of business in the 1997-2001 underwriting years. The professional lines claims activity arises largely from a limited number of cedents. This reserve increase was partially offset by favorable development in the 1997-2001 underwriting years in the medical malpractice business line. Activity in the post-2001 underwriting years relates primarily to certain large individual claims affecting a number of lines, including surety, umbrella liability and errors and omissions.
In the fourth quarter 2003, the Company reduced aviation loss reserves related to the September 11 event by $197.0 million. This reduction was due to higher than expected levels of participation (97%) in the September 11 Victim Compensation Fund, a no-fault compensation scheme funded by the U.S. Government which closed on December 22, 2003. This resulted in a reduction in the estimated ultimate losses by the Company for this event.
The nature of the Company’s high excess of loss liability and catastrophe business can result in loss events 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 continue in the future. Accordingly, it is inappropriate to extrapolate future redundancies or deficiencies based upon historical experience.
The Company’s reserving process includes a continuing evaluation of the potential impact on unpaid liabilities from exposure to asbestos and environmental claims, including related loss adjustment expenses. Liabilities are established to cover both known and incurred but not reported claims.
A reconciliation of the opening and closing unpaid losses and loss expenses related to asbestos and environmental exposure claims related to business written prior to 1986 for the years indicated is as follows:
The estimation of loss and loss expense liabilities for asbestos and environmental exposures is subject to much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: (i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; (ii) the lack of reliability of available historical claims data as an indicator of future claims development; (iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and (iv) the potential of insurers and reinsurers to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of loss and loss expense liabilities beyond recorded reserves can be established. As the Company’s net unpaid loss and loss expense reserves related to asbestos and environmental exposures are less than 1% of the total net reserves at December 31, 2005, further adverse development is not expected to be material to the Company’s overall net loss reserves. The Company believes it has made reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues that would significantly affect its estimate for loss and loss expenses.
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $1.7 billion, $3.0 billion and $1.9 billion for the years ended December 31, 2005, 2004 and 2003, respectively. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $2.1 billion at December 31, 2005, collateralizing reinsurance recoverables with respect to certain reinsurers.
At December 31, 2005, the provision for uncollectible reinsurance was $260.7 million. To estimate this provision, the reinsurance recoverable must first be allocated to applicable reinsurers. This determination is based on a process rather than an estimate, although an element of judgment must be applied. As part of this process, ceded IBNR is allocated by reinsurer. The allocations are generally based on historical relationships between gross and ceded losses. If actual experience varies materially from historical experience, the allocation of reinsurance recoverable by reinsurer will change.
The Company uses a default analysis to estimate uncollectible reinsurance. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral, and default factors used to determine the portion of a reinsurer’s balance deemed uncollectible. The definition of collateral for this purpose requires some judgment and is generally limited to assets held in trust, letters of credit, and liabilities held by us with the same legal entity for which the Company believes there is a right of offset. Default factors require considerable judgment and are determined using the current rating, or rating equivalent, of each reinsurer as well as other key considerations and assumptions.
At the time of the Winterthur International acquisition, WSIC provided to the Company a liquidity facil- ity. At the time of the payment of the net reserve seasoned amount on December 12, 2005, the Company exercised its right to repay up to the balances outstanding on this facility by assignment to WSIC of an equal amount of receivables relating to reinsurance recoverables selected by the Company. During December 2005, the Company assigned $265.4 million of receivables to WSIC under this arrangement, although WSIC has disputed the assignment of certain of these receivables.
The Company has entered into certain contracts with cedents that transfer insufficient risk to be accounted for as insurance or reinsurance transactions. These contracts 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 estimated ultimate liability. The Company establishes an initial accretion rate at inception of the contract, which is reviewed and adjusted periodically based on claims activity. Guaranteed investment contracts are initially recorded at an amount equal to the assets received. The Company also has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the estimated ultimate liability. The Company establishes an initial accretion rate at inception of the contract, which is based on the contractual payment schedule.
(1) “Commitment” and “In Use” data represent December 31, 2005 accreted values.
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. 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.
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 11.5 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 7.0% 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 $80.6 per share. Because the average market price of the Company’s ordinary shares during the period the 7.0% 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 three and twelve month periods ended December 31, 2005.
In September 2004, the Company created a new $100 million unsecured bilateral credit facility that was unutilized during 2004 and at December 31, 2004. Of the aggregate amount of $100 million, $60 million was available as revolving credit and up to $100 million is available in the form of letters of credit, with the combined total not to exceed $100 million. This facility was replaced in December 2005.
In March 2004, the Company issued 33 million 6.5% Equity Security Units (the “6.5% Units”) in a public offering. The Company received approximately $800.2 million in net proceeds from the sale of the Units after deducting underwriting discounts. Each 6.5% 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 May 15, 2007 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2009 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 3.97% and 2.53% under the purchase contracts and senior notes, respectively. The Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In May 2007, 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 6.5% Unit holders’ obligations under the purchase contract. If the senior notes are not successfully remar-keted, 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 6.5% Unit holders’ obligations to purchase its ordinary shares under the purchase contracts.
In connection with this transaction, $88.6 million, which is the estimated fair value of the purchase contract, was charged to “Additional paid in capital” and a corresponding liability was established. Of the $26.9 million total costs associated with the issuance of the 6.5% Units, $23.7 million was charged to “Additional paid in capital” with the remainder deferred and amortized over the term of the senior debt.
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, 2004 and 2005.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also 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 $109.9 million was charged to “Additional Paid in Capital” and a deferred liability was established (included with “Other liabilities”) of $102.5 million in the Consolidated Balance Sheet at December 31, 2003. The Company began to amortize this liability that resulted in additional interest expense
of approximately $3.5 million in 2004 and $2.0 million in 2003 and the liability will continue to be amortized over a ten year term.
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.
The 6.5% Guaranteed Senior Notes indentures contain a cross default provision. In general, in the event that the Company defaults in the payment of indebtedness in the amount of $50.0 million or more, an event of default would be triggered under both the 6.5% Guaranteed Senior Notes indentures.
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 aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
The following table summarizes these instruments and the effect on net income in the years ended December 31, 2005, 2004 and 2003:
The Company uses foreign exchange contracts to manage its exposure to the effects of fluctuating foreign currencies on the value of certain of its foreign currency fixed maturities and equity securities investments. These contracts are not designated as specific hedges for financial reporting purposes and therefore, realized and unrealized gains and losses on these contracts are recorded in income in the period in which they occur. These contracts generally have maturities of twelve months or less. In addition, certain of the Company’s investment managers may, subject to investment guidelines, enter into forward contracts where potential gains may exist. The Company has exposure to foreign currency exchange rate fluctuations through its operations and in its investment portfolio. The Company’s net foreign currency denominated payable on foreign exchange contracts was $603.0 million and 3.8 million as at December 31, 2005 and 2004, respectively, with a net unrealized gain of $15.9 million as at December 31, 2005 and a net unrealized loss of $11.8 million as at December 31, 2004.
At December 31, 2005, contracts designated as fair value and cash flow hedges were in a $23.5 million net unrealized gain position. As a result of the fair value hedges, deposit liabilities were increased by $27.6 million at December 31, 2005. The ineffective portion of the hedge amounted to $5.0 million as part of net realized losses. The interest rate swap hedges resulted in a reduction in interest expense and a reduction in net investment income of $6.7 million and $4.5 million, respectively, for the year ended December 31, 2005.
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.
In 2003, the Company entered into an aggregate of $500.0 million of commercial paper-based credit facilities (the “Credit Facilities”). The proceeds of advances under the Credit Facilities were used to fund a trust account (“Trust”) to collateralize the reinsurance obligations of the Company under an intercompany quota share reinsurance agreement. 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 were to not have the right to offset such assets (as, for example, would be the case if the assets in the Trust were withdrawn in order to satisfy the Company’s reinsurance obligations or if lender-issued securities could
not be held in the Trust because they did not qualify as permitted assets under the trust agreement), then all or a portion of the assets in the Trust and the Company’s repayment obligations under the Credit Facilities would be required to be included as assets and liabilities on a gross basis, respectively, on the Company’s balance sheet.
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 $652.0 million and $505.8 million at December 31, 2005 and 2004, 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.
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, 2005 and 2004 amounted to $7.5 billion and $7.8 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.
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”) primarily to extend its predominantly North American-based large corporate insurance business globally.
As a part of this transaction the WSIC provides protection to the Company with respect to third party reinsurance receivables and recoverables related to the Winterthur Business, which are $1.6 billion in the aggregate as of December 31, 2005. There are two levels of protection from WSIC for these balances:
At the time of the Winterthur International acquisition, the seller provided to the Company a liquidity facil- ity. At the time of the payment of the net reserve seasoned amount on December 12, 2005, as described above, the Company exercised its right to repay up to the balances outstanding on this facility by assign- ment to WSIC of an equal amount of receivables relating to reinsurance recoverables selected by the Company. During December 2005, the Company assigned $265.4 million of receivables to WSIC under this arrangement, although WSIC has disputed the assignment of certain of these receivables.
At December 31, 2005, certain reinsurers responsible for some portions of the reinsurance of the Winterthur Business have raised issues as to whether amounts claimed are due and discussions are currently ongoing to achieve a resolution.
During 2003, the Company entered into a purchase, sale and leaseback transaction to acquire new office space in London. The Company has recognized a capital lease asset of $152.9 million and $185.2 million, and deferred a gain of $46.5 million and $54.5 million related to this lease at December 31, 2005 and 2004, respectively. The gain is being amortized to income in line with the amortization of the asset. The future minimum lease payments in the aggregate are expected to be $319.5 million and annually for the next five years are as follows:
The Company is a Cayman Islands corporation and, except as described below, neither it nor its non-U.S. subsidiaries have paid United States corporate income taxes (other than withholding taxes on dividend income) on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the United States. However, because definitive identification of activities which constitute being engaged in a trade or business in the United States is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there can be no assurance that the Internal Revenue Service will not contend that the Company or its non-U.S. subsidiaries are engaged in a trade or business or otherwise subject to taxation in the United States. If the Company or its non-U.S. subsidiaries were considered to be engaged in a trade or business in the United States (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the United States and Bermuda and other countries in which the Company operates, such businesses were attributable to a “permanent establishment” in the United States), the Company or such subsidiaries could be subject to U.S. tax at regular tax rates on its taxable income that is effectively connected with its U.S. trade or business plus an additional 30% “branch profits” tax on such income remaining after the regular tax, in which case there could be a significant adverse effect on the Company’s results of operations and financial condition.
At December 31, 2005 and 2004, $3.5 billion and $3.0 billion of letters of credit, respectively, were outstanding, 5.3% and 6.6% of which were collateralized by the Company’s investment portfolio, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements.
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each. Holders of Class A ordinary shares are entitled to one vote for each share. All ordinary shares in issue at December 31, 2005 are Class A ordinary shares.
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 insured hurricane losses during the 2005 Atlantic hurricane season and the conclusion of the loss related to the independent actuarial process with Winterthur Swiss Insurance Company. The net proceeds from this issuance was $2.4 billion.
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 Preference Shares ($25 per share redemption price). The proceeds were used for general corporate purposes.
The Company has had several stock repurchase plans as part of its capital management program. On January 9, 2000, the Board of Directors authorized the repurchase of shares up to $500.0 million. During 2001, the Company repurchased 1.5 million ordinary shares at a total cost of $116.9 million, or an average cost of $76.40 per ordinary share. During 2000, the Company repurchased 5.1 million ordinary shares at a total cost of $247.7 million, or an average cost of $48.82 per ordinary share. During 2005, 2004 and 2003 no share repurchases took place under the January 9, 2000 authorization. The Company has repurchased shares from employees and directors in relation to share swaps on option exercises and withholding tax on restricted stock.
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 three or four years from date of grant.
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
Total stock-based compensation expensed, which related to amortization of restricted stock, was $33.0 million, $28.4 million, and $17.9 million in 2005, 2004, and 2003, respectively.
During 2004, 295,000 options were granted with an exercise price of $88.00 and the market price was $77.10.
The following table summarizes information about the Company’s stock options (including stock appreciation rights) for options outstanding as of December 31, 2005:
The Company has a qualified defined contribution plan which is managed externally and whereby employees and the Company contribute a certain percentage of the employee’s gross salary into the plan each month. The Company’s contribution generally vests over 5 years. The Company’s expenses for its qualified contributory defined contribution retirement plans were $40.9 million, $38.8 million and $27.5 million in the years ended December 31, 2005, 2004 and 2003, respectively.
A qualified non-contributory defined benefit pension plan exists to cover a number of 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 plan assets were $29.4 million, $29.4 million and $14.2 million, respectively, as of December 31, 2005, and $27.0 million, $27.0 million and $13.8 million, respectively, as of December 31, 2004.
In the first quarter of 2002, the Company curtailed its qualified non-contributory defined benefit plan. Under the terms of the curtailment, eligible employees will not earn additional defined benefits for future services. However,
During 2003, all pension benefits and retirement plans for Winterthur International employees were transitioned into the Company’s defined contribution plan.
In 2005 and 2004, the Company paid dividends of $40.3 million, respectively, to Series A and Series B preference shareholders.
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 under the principles of the consolidated tax provisions of the Internal Revenue Code and Regulations thereunder. Should the U.S. subsidiaries pay a dividend to the Company, withholding taxes will apply.
The Company has operations in subsidiary and branch form in various other jurisdictions around the world, including but not limited to the U.K., Switzerland, Ireland, Germany, France, Luxembourg and various countries in Latin America that are subject to relevant taxes in those jurisdictions.
The income tax provisions for the years ended December 31, 2005, 2004 and 2003 are as follows:
U.S. net operating loss carry forwards at December 31, 2005 were approximately $18.4 million and will expire in future years through 2024. As of December 31, 2005, net operating loss carry forwards in the U.K. were approximately $332 million and have no expiration. As of December 31, 2005, net operating loss carry forwards in Switzerland were approximately $554 million and will expire in future years through 2012.
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.S. group and UK 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.S. group and its UK 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.S. group, management has determined that the projected U.S. consolidated taxable income will be sufficient to utilize the net operating losses of approximately $18.4 million within a reasonable period. With regard to the UK group, management has determined that the projected UK group taxable income (using UK rules for group loss relief) will be sufficient to utilize the net operating losses of approximately $332 million. Management will continue to evaluate income generated in future periods by the U.S. group and the UK group in determining the reasonableness of its position. If management determines that future income generated by the U.S. group or UK 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.S. portion of the net deferred tax asset, in the amount of $6.4 million and for the UK portion of the net deferred tax asset, in the amount of $99.6 million.
(1) Required statutory capital and surplus represents 100% RBC level for principle U.S. operating subsidiaries.
At December 31, 2005, the Company owned minority stakes in eight independent investment management companies (“Investment Management Affiliates”). These ownership stakes are part of the Company’s asset management strategy, pursuant to which the Company seeks to develop relationships with specialty investment management organizations, generally acquiring an equity interest in the business. The Company also invests in certain of the funds and limited partnerships and other legal entities managed by these affiliates and through these funds and partnerships pay management and performance fees to the Company’s Investment Management Affiliates.
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 $4.1 billion as of December 31, 2005.
The following is a summary of the unaudited quarterly financial data for 2005 and 2004:
In the third quarter at 2004, the Company recorded net loss and loss expenses of $446.8 million in relation to the 2004 Atlantic hurricane season, which resulted in four insured hurricanes aggregating to the largest seasonal loss in history. In the fourth quarter of 2004 that loss estimate was increased by $69.8 million. In addition, the Company incurred net loss and loss expenses of $74.6 million in relation to the tsunami in South Asia in December of 2004.