The Company operates in the United States, Bermuda, Europe and various other locations around the world. In 1997, the Company acquired commercial real estate in Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The development was completed in April 2001. The total cost of this development, including land, was approximately $126.6 million.
In addition, the Company owns XL House in London, England, acquired as part of the Winterthur International acquisition, and the fair value of this property at December 31, 2003 was approximately $38.3 million. The majority of all other office facilities throughout the world that are occupied by the Company and its subsidiaries are leased.
Results for all periods subsequent to July 1, 2001 include the results of Winterthur International, which was acquired with effect from this date. The results also include the consolidation of XL Re Europe, which has been accounted for as a subsidiary with effect from January 1, 2002. In the years ended December 31, 2001, 2000 and 1999, the Company’s share of net income of Le Mans Ré (now known as XL Re Europe) was included in equity in net income of insurance and operating affiliates. The Company’s net income for the years ended December 31, 2003, 2002 and 2001 was impacted by the September 11 event. See Item 8, Note 4 to the Consolidated Financial Statements. The effect of all of these items should be considered when making period to period comparisons of the Company’s results of operations and financial condition and liquidity. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis.
Certain aspects of the Company’s business have loss experience characterized as low frequency and high severity. This may result in volatility in both the Company’s results of operations and financial condition.
The Company has grown through acquisition activity and developing new business opportunities. Acquisitions included Global Capital Underwriting Ltd in 1996, Mid Ocean Limited in 1998, ECS, Inc. and NAC Re Corp. in 1999, Winterthur International in 2001 and Le Mans Ré in 2002. All acquisitions have supported the Company’s strategic plan to develop a global platform in insurance and reinsurance. Recent business developments include XL Capital Assurance Inc. and XL Financial Assurance Ltd., the Company’s financial guarantee primary and reinsurance guarantors, XL Weather & Energy and XL Life & Annuity. As a result of these combined developments, the Company now competes as an integrated global business with more than 3,300 employees in 30 countries.
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 2003 and 2002 have been negatively impacted by an increase to reserves established in prior years primarily relating to its North American casualty business written in the 1997 through 2001 underwriting years. In the third quarter of 2003, the Company received reported claims that were in excess of the Company’s expected claims and the Company increased loss reserves by $184.0 million and began an extensive claims audit review of its ceding companies
for this book of business. Upon completion of this claims audit review as well as the Company’s scheduled annual reserve review, the Company increased loss reserves by $694 million in the fourth quarter of 2003. This increase was net of a $197 million release of reserves relating to the September 11 event. See further information under “Reinsurance - General Operations” below.
The following are some of the financial measures management considers important in evaluating the Company’s operating performance in the Company’s general operations:
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 adverse development of prior year loss reserves and the September 11 event. Partially offsetting this has been the increase in premium rates 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 2004.
Net investment income from its general operations is an important measure which 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 affected by overall market interest rates and also the size of the portfolio. The size of the portfolio is impacted by cash flow generated from operations, which has been positive during the last three years and which the Company currently expects to be positive in 2004.
Another important matter on which management is focused (and which also affects the Company’s ability to underwrite business) is the availability of collateral, including letters of credit, insurance trusts and other credit facilities required to provide security to cedants (these are companies who reinsure their liabilities to the Company), particularly as required by state insurance regulation in the U.S. and at Lloyds, and also to provide the Company with liquidity as required. These facilities are provided to the Company from commercial banks and generally are renewed every year. The Company has also utilized “off balance sheet” transactions in order to obtain more collateral capacity (these transactions are described below under “Variable Interest Entities and Other Off Balance Sheet Arrangements” below). As the Company writes more business, its collateral requirements increase. A key challenge for management is to ensure that sufficient collateral capacity is available as to not hinder future writings of business.
the SPA. At December 31, 2003, the Company had recorded an unsecured reinsurance net recoverable from the Seller in the amount of $740.9 million due to unfavorable development in the acquired operations’ loss and unearned premium reserves. This amount remains subject to change in view of ongoing net reserve development prior to June 30, 2004. In the event that the Seller disagrees with the Seasoned Net Reserves Amount as determined by the Company, the SPA provides for a dispute resolution procedure that ultimately would result in the determination of such amount by a named independent actuary.
As a property and casualty company, the Company must ensure that it has sufficient funds to settle claims promptly, especially in the event of a major catastrophic event. Management is focused on making sure that liquidity requirements are supported by both having lines of credit facilities available to the Company as well as the Company’s general investment portfolio of which the majority is in high grade fixed income securities. The Company has had significant positive cash flow from operations in the three years ended December 31, 2003 generated from its underwriting activities (premiums less claim and expense settlements) as well as the receipt of investment income on its portfolio. This is due to current favorable underwriting conditions as well as growth of the investment portfolio and the Company expects cash flow from operations to be strong in 2004.
The Company’s net income (loss) and other financial measures as shown above for the three years ended December 31, 2003 have been affected, among other things, by the following significant items :
Net adverse prior period loss development occurs when there is an increase to loss reserves recorded at the beginning of the year, resulting from actual or reported loss development for prior years exceeding expected loss development. The net adverse prior period loss development in the three years ended December 31, 2003 related primarily to the Company’s general reinsurance operations and principally to losses on business written in 1997 through 2001 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 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 for a total of $663 million in the fourth quarter 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 cedant review program accordingly.
See further discussion under “Critical Accounting Policies and Estimates” and within the reinsurance segment operations below.
In the year ended December 31, 2001, the Company’s results were negatively impacted by a pre-tax loss of $932.7 million related to the September 11 event, in the general operations insurance and reinsurance segments. During the second quarter 2002, the Company increased loss reserves by $200.0 million in both the insurance and reinsurance segments following the receipt of updated loss information. In the fourth quarter 2003, the Company released loss reserves related to the reinsurance segment, primarily aviation lines, due to the higher than expected levels of participation (97%) in the September 11 Victims 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 Company’s estimated ultimate losses for this event.
Effective July 1, 2001, the Company acquired certain Winterthur International insurance operations primarily to extend its predominantly North American based large corporate insurance business globally. This acquisition had a significant effect on the Company’s premium written, results of operations and financial condition.
1) Unpaid Losses and Loss Expenses and Unpaid Loss and Loss Expenses Recoverable
a) Case reserves - reserves for reported losses and loss expenses that have not yet been settled and,
At December 31, 2003 and 2002, the Company’s total gross reserves for unpaid losses and loss expenses were $16.6 billion and $13.2 billion, respectively, of which $8.4 billion and $7.7 billion related to case reserves for reported claims and $8.2 billion and $5.5 billion for IBNR reserves, respectively.
With respect to the Company’s financial products and services financial operations, financial guaranty claims written on an insurance basis are established consistent with the Company’s insurance operations and financial guaranty claims written on a reinsurance basis are established consistent with the Company’s reinsurance operations.
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, meaning that the Company’s liability is after large deductibles including self insurance or insurance from sources other than the Company. The Company commenced writing this type of business in 1986 and issued policies in forms that were different from traditional policies used by the industry at that time. Initially, there was a lack of industry data available for this type of business. Consequently, the basis for establishing loss reserves by the Company for this type of business was largely judgmental and based upon the Company’s own reported loss experience which was used as basis for determining ultimate losses, and therefore IBNR reserves. Over time, the amount of available historical loss experience data of the Company has increased. As a result, the Company has obtained a larger statistical base to assist in establishing reserves for these excess casualty insurance claims.
In addition, reinsurance operations by their nature add further complications to the reserving process particularly for casualty business written, in that there is an inherent lag in the timing and reporting of a loss event from an insured or ceding company to the reinsurer. This reporting lag creates an even longer period of time between the policy inception and when a claim is finally settled. As a result, more judgment is required to establish reserves for ultimate claims in the Company’s reinsurance operations.
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 include 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.
The Company’s net unpaid loss and loss expense general and financial reserves broken down by operating segment at December 31, 2003 and 2002 was as follows:
The following table shows the recorded estimate and the high and low ends of the range of reserves for each of the lines of business noted above at December 31, 2003:
The development of a reserve range models the uncertainty of the claim environment as well as the limited predictive power of past loss data. These uncertainties and limitations are not specific to to the Company. The ranges represent an estimate of the range of possible outcomes over a one year development period. A range of possible outcomes should not be confused with a range of best estimates. The range of best estimates will generally be much narrower than the range of possible outcomes as it will reflect reasonable actuarial and management best estimates of the expected reserve.
Set forth below is information regarding the numbers of claims and paid claim amounts reported and paid for high layer excess casualty insurance for December 31, 2000 through December 31, 2003:
Discontinued asbestos and long-tail environment business had been previously written by NAC Re (now known as XL Reinsurance America, Inc), prior to its acquisition by the Company, see Item 8, Note 10 to the Consolidated Financial Statements.
Future policy benefit reserves relate to the Company’s life and annuity operations and are estimated using assumptions for investment yields, mortality, expenses and provisions for adverse loss deviation. Interest rate volatility and mortality experience may affect the ultimate benefit payments.
Most of the Company’s future policy benefit reserves relate to immediate annuity portfolio reinsurance contracts under which the Company makes annuity payments throughout the term of the contract for a specified portfolio of policies. For certain of these contracts, a single premium is paid at inception of the contract by way of a transfer of cash and investments to the Company.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $2.6 billion and $2.1 billion at December 31, 2003 and 2002, respectively. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile.
As stated above, the future policy benefit reserves include provisions for adverse deviation in excess of best estimate assumptions that amounted to approximately $125 million and $60 million at December 31, 2003 and 2002, 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 $9 million if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions. A decrease of 0.1% in the investment yield would result in a $24 million increase in the value of future claims related to annuity portfolio reinsurance.
million, while a 1% increase in the morbidity rate would increase the value of future claims by approximately $0.6 million.
The Company’s deposit liabilities at December 31, 2003 included both structured finite insurance and reinsurance transactions as well as funding agreements and municipal guaranteed reinvestment contracts. With regard to the structured finite insurance and reinsurance contracts, the Company uses a portfolio rate of return of equivalent duration to the liabilities in determining risk transfer. For these contracts, the initial deposit liability equals the cash received at inception. 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. The deposit accretion rate is the rate of return required to fund expected future payment obligations (this is equivalent to the ‘best estimates’ of future cash flows), which are determined actuarially based upon the nature of the underlying indemnifiable losses. This is a function of the ultimate size of such losses, the impact of the contractual limits upon indemnification of such losses, and the underlying loss settlement process which determines the timing of payments. An increase in the ultimate claims cost or accelerated claims settlement would potentially lead to an increase in the deposit liability accretion rate or lead to incurred losses if significant. The Company has not had any significant change in these assumptions during the last three years ended December 31, 2003.
Interest expense related to the structured finite insurance and reinsurance contracts was $92.9 million, $65.9 million and $47.9 million was recorded related to the accretion of the deposit liabilities for the years ended December 31, 2003, 2002 and 2001, respectively. For some of the Company’s deposit liabilities the accretion rate is recorded at its contractual limit. For all other contracts, a 1% increase in the average accretion rate would result in an increase in deposit liabilities and interest expense by $11.9 million on an annualized basis.
The Company conducts activities in three main types of derivative instruments: credit derivatives, weather and energy derivatives and investment related derivative instruments. The estimate of fair value for credit derivatives and weather and energy derivatives requires management’s judgment. These two activities are discussed below:
Management estimates fair value for investment grade exposures by monitoring changes in credit quality and selecting appropriate market indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value. For credit derivatives that are non-investment grade and therefore do not have a readily determinable market value, the Company uses an alternative fair value methodology. The fair value is determined using a cash flow model developed by the Company and is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. Installment premiums are also considered in the determination of discounted net cash flows. Other elements of the change in fair value are based upon pricing established at the inception of the contract. Changes in fair value are unrealized as the credit derivatives are not traded to realize this value. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for
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 which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors. See Item 7A, “Quantitative and Qualitative Disclosure About Market Risk” for sensitivity analysis.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security with an unrealized loss represents an other than temporary decline. However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its ability to hold such securities is supported by positive and sufficient cash flow from its operations in order to meet its claims payment obligations arising from its underwriting operations without selling such investments. In this regard, cash flow from operating activities was $3.4 billion and $3.0 billion in 2003 and 2002, respectively.
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.
Effective as of January 1, 2004, XL Re America Inc (“XLRA”), a subsidiary of the Company, entered into an adverse development reinsurance treaty with another reinsurance subsidiary of the Company. The treaty related to the 1985 through (and including) 2001 underwriting years covering any adverse development on reserves calculated as of December 31, 2003 between January 1, 2004 and December 31, 2005. The treaty has a limit of $500 million and will limit future loss development at XLRA relating to these underwriting years. Any commutation of this treaty requires the prior approval of the New York Department of Insurance. There is no impact of this treaty on the consolidated financial statements of the Company, however as part of management’s continuing evaluation of its deferred tax asset, the treaty is critical in evaluating the future income position of the U.S. group of companies. Management believes that the treaty will protect the U.S. group from unexpected prior loss development. Absent unexpected loss development from the 2001 and prior underwriting years, management has concluded that there is sufficient positive evidence of future profitability in the U.S. and that a valuation allowance as a charge against the deferred tax asset is not required at this time.
See further information under “- Other Revenues and Expenses” and Item 8, Note 23 to the Consolidated Financial
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 depends 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.
The Company is organized into three underwriting segments - insurance, reinsurance, and financial products and services - and a corporate segment, which includes the investment operations of the Company. See Item 1 and Item 8, Note 3 to the Consolidated Financial Statements for further information.
The Company’s business is conducted on a global basis where several of its subsidiaries operate in foreign currencies that are the base currency of that entity. Under U.S. GAAP, revenues and expenses of those operations are translated into the U.S. dollar at average exchange rates during the year and assets and liabilities at exchange rates at the end of the year. In 2003 and 2002, with the decline in value of U.S. dollar against several currencies, including U.K. sterling, Swiss franc and the Euro, this has resulted in revenues and expenses translated into higher U.S. dollar values. This should be considered when making period to period comparisons.
Fee income and other decreased in 2003 as compared to 2002 and increased in 2002 as compared to 2001 primarily due to $21.0 million of contingent income received in the fourth quarter of 2002 that related to a sale in 1999 of the motor business written by the Company’s Lloyd’s syndicates. In addition, at the end of 2002, the Company discontinued certain consulting and administration services related to the Winterthur International operations for employee benefit plans of unrelated companies.
Exchange gains in 2003 and 2002 were primarily due to a decline in the value of the U.S. dollar against U.K. sterling and Swiss franc in those operations that have monetary assets and liabilities denominated in these foreign currencies. 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 loss ratio was higher in 2003 as compared to 2002 due primarily to an increase in the net adverse development of prior year loss reserves that was partially offset by a relatively lower level of current year loss activity with the positive effect of continued pricing increases and improved terms and conditions across most lines written. The loss ratio was lower in 2002 as compared with 2001 due primarily to the September 11 event.
The Company did not change its methodology or key assumptions used in 2003, 2002 or 2001 to determine ultimate loss reserves for any line of insurance business written.
In 2002, the increase in the estimate of the ultimate losses relating to the September 11 event of $73 million related primarily to the accident and health business written in the Company’s Lloyd’s operations. The Company had originally recorded ultimate losses for the September 11 event in the insurance segment of $318 million in 2001 based on management’s best estimate at that time. This best estimate was based on an analysis which had been performed to attempt to identify all possible claims and to analyze the magnitude of the potential loss. The increase in the loss reserves occurred in the second quarter of 2002 after the Company received additional information from policyholders with regard to claims relating to their insured employee casualties, including estimates of benefits payable under U.S. workers’ compensation statutes.
Net premiums earned in 2003 increased 18.1% as compared to 2002 due primarily to growth in net premiums written in 2003 and 2002. Casualty reinsurance net premiums earned were $971.2 million in 2003 as compared to $792.6 million in 2002.
Net premiums earned in 2002 also increased as compared to 2001 due to new business written and pricing increases, In addition, 2002 included net premiums earned of $241.5 million related to XL Re Europe. Further, net premiums earned in 2001 were also reduced by $120.4 million of net reinstatement premiums related to the September 11 event.
There were no significant catastrophic loss events affecting the Company in 2003 or 2002. In 2001 other current year loss events, excluding the September 11 event, totaled approximately $93.0 million. Property catastrophe business has loss experience that is generally categorized as low frequency but high severity in nature. This may result in volatility in the Company’s financial results for any fiscal year or quarter.
The loss and loss expense ratio increased in 2003 as compared to 2002 due primarily to net adverse development of prior year loss reserves primarily related to the Company’s North American casualty business written during the 1997 through 2001 underwriting years. See further discussion below.
The increase in the underwriting expense ratio in 2003 as compared with 2002 was due to an increase in the acquisition expense ratio of 0.8% and operating expense ratio of 0.9%. The increase in the acquisition expense ratio was due primarily to higher ceding company profit commissions payable and a change in the mix of net premiums earned. The operating expense ratio increased due primarily to a reduction of operating expenses in 2002 of approximately $8.0 million in recognition of a curtailment gain on a Company pension plan in the U.S.
The underwriting expense ratio in 2001 was affected by the negative impact of the September 11 event reinstatement premiums on net premiums earned. Excluding the effect of the reinstatement premiums the underwriting expense ratio would have been 33.0% in 2001 as compared to 27.3% in 2002. The reduction in the underwriting expense ratio in 2002 was due primarily to a change in the mix of business in net premiums earned where certain lines had a lower commission rate and also due to the growth in net premiums earned being greater than the growth in operating expenses. Operating expenses generally do not change in direct proportion to changes in net premiums earned, particularly where they are due to price changes. Partially offsetting this was a reduction in 2001 of approximately $7.0 million related to certain compensation expenses accrued in previous years.
The following is an analysis of the net adverse prior year development during each of the three years ended December 31, 2003 :
The main lines of business affected by this adverse development included general liability, medical malpractice, professional and surety lines. As previously noted, the Company’s expected loss development is actuarially determined based on historical claims analysis and projected trends. Actual reported losses may vary from expected loss development from quarter to quarter. Generally, as an underwriting year matures, the level of newly reported claims decreases and typically, unless the Company receives additional reported claims that are significantly higher or lower than expected, estimated ultimate loss reserves are not adjusted prior to a full actuarial review. In the third quarter of 2003, the Company received a significant increase in reported claims that were in excess of the Company’s expected claims development. In addition, the Company completed an actuarial review for the longer tail lines of this book of business, using data evaluated at March 31, 2003. As a result, the Company recorded an increase in loss reserves of $184.0 million in the third quarter of 2003. This adverse development has been due to several factors - competitive market pressures on pricing during these underwriting years caused premium rates for excess casualty business to decline industry wide and there has been an increase in the number and size of claims reported in recent years as a result of increases in court filings, corporate scandals, rising tort costs and settlement awards.
As a result of this increase in prior period loss reserves in the third quarter of 2003, the Company completed an extensive claims audit review at the relevant ceding companies in order to obtain information to more accurately determine an estimate of the ultimate loss reserves for this book of business. The claims audit review included both internal and external resources, a comprehensive claims audit of the largest and most significant ceding companies, and a review of loss ratios and reserve analysis procedures. Additional case reserves and potential additional loss exposure were identified during the review and upon completion of the claims review, the Company recorded a further increase to net loss reserves of $663.0 million in the fourth quarter of 2003 primarily related to the Company’s North American casualty
reinsurance business written in the 1997 through 2001 underwriting years. This comprised additional case reserves of $124.0 million and an increase in IBNR reserves of $539.0 million.
As a result of the new information obtained in the claims audit review, the Company changed its actuarial methodology and key assumptions for determining ultimate loss reserves. The Company separately reviewed the historical loss development of its major cedents using several actuarial methodologies; where the analysis of a cedent’s experience concluded that the experience was worse than the Company’s historical loss development experience, the Company projected that cedent’s ultimate loss based on the cedent’s own experience. In addition, the Company assumed that the more recent experience was more indicative of future loss development by selecting development patterns that were based on the most recent experience rather than on the Company’s longer term historical experience.
During 2003, the Company reviewed its actual reported loss experience for asbestos and environmental claims for its 1985 and prior exposures. The actual loss experience was consistent with assumptions established in the Company’s 2002 review and therefore there was no adverse prior year development of the Company’s asbestos and environmental reserves in 2003. The reserves for these exposures represented less than 1% of the Company’s total unpaid loss and loss expense reserves at December 31, 2003.
The Company updated its assumptions for asbestos loss reserves in 2002 to take account of an increase in 2002 in the number and size of the ultimate asbestos claims that the Company anticipates on the policies underwritten during the years 1972 through 1985. These changes were based on recent increases in court filings and settlements on behalf of asbestos claimants and bankruptcies of asbestos defendants which tend to shift liabilities to other parties. The Company’s increase of $30 million in 2002 increased its total net reserves for asbestos and environmental exposures to $66 million.
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, 2003, further adverse development is not expected to be material to the Company’s overall net loss reserves. See Item 8, Note 10 to the Consolidated Financial Statements for further information.
During 2001, the Company’s prior estimate of the year-end net reserves increased by $253 million. The increase in 2001 related principally to loss estimates for losses occurring in 1998 through (and including) 2000 related to the Company’s casualty reinsurance business. The reasons were the same as those explained above. The Company did not change its methodology or key assumptions in 2001.
Life gross and net premiums written, net premiums earned and claims and policy benefits in the three years ended December 31, 2003 included the assumption of the following long duration annuity portfolios:
3. Fourth quarter of 2001 - one European portfolio of approximately $549.3 million
Acquisition costs, operating expenses and net investment income increased in 2003 as compared to 2002 in line with the expansion of this business.
Fee income and other in 2002 and 2001 related primarily to liquidity facility fees earned from one of the Company’s financial guaranty contracts. In 2003, fee income primarily related to an early termination fee received on one financial guaranty contract. Fee income and other is expected to decrease in 2004 as early terminations are not anticipated.
As with the Company’s property and casualty insurance and reinsurance operations, net losses and loss expenses include current year net losses incurred and adverse or favorable development of prior year net loss and loss expenses reserves. In 2002, net losses incurred were negative due to favorable development of prior year loss and loss expense reserves, described below. The following tables present the favorable development of the Company’s gross and net loss and loss expense reserves for its general financial products and services operations:
In 2001, the Company did not change its prior year loss reserves because it did not have sufficient Company-specific loss experience data available to justify amending the Company’s initial assumptions.
Operating expenses increased in 2003 as compared to 2002 and 2002 as compared to 2001 due to expansion of all activities in the segment.
The net realized and unrealized gains on weather and energy risk management derivative instruments were lower in 2003 as compared to 2002 primarily due to losses from natural gas based exposures in 2003 that was partially offset by a positive mark-to-market adjustment in weather based exposures. In 2003, the energy group established and traded financial gas positions in the U.S. natural gas markets but at year end December 31, 2003, both the positions and activity were significantly reduced and future participation is expected to be limited.
period results have been amended to conform to this change. The Company had net realized and unrealized losses of $25.8 million, $46.1 million and $19.4 million in the years ended December 31, 2003, 2002 and 2001, respectively, related to the fair value adjustment for credit derivatives. These losses are mainly unrealized and related to the deterioration of credit quality for certain credit pools, widespread ratings downgrades of corporate obligors, and certain specific credit events reported in the year on a small number of transactions. The year ended December 31, 2002 was also affected by a significant widening of credit spreads. The Company continues to monitor its credit exposures and establish reserves as required.
Net premiums earned, claims and policy benefit reserves and acquisition costs all related to this novated block of business. During the quarter ended September 30, 2003, the Company exercised its right and terminated a retrocession agreement of certain of these exposures, which led to a higher percentage increase in net premiums written than gross premiums written.
The Company commenced writing municipal reinvestment contracts in 2002 and funding agreements in 2003 whereby the Company receives cash and deposits and pays interest at a contractual interest rate. The Company has investment risk related to its ability to generate sufficient investment income to enable the total invested assets to cover the payment of the ultimate liability. Net investment income and interest expense in 2003 related to these transactions and at December 31, 2003, the Company had written approximately $1.5 billion of municipal reinvestment contracts and $550 million of funding agreements.
Equity in net income of investment affiliates in 2003 includes income on the alternative investment portfolio for eleven months ended November 30, 2003 as compared to twelve months in December 2002 and 2001. The Company determined it was necessary to record the investment affiliates on a one month lag in order for the Company to meet the accelerated filing deadlines as specified by the Securities and Exchange Commission. The fair market values of certain of these alternative investments often take longer to obtain as compared to other of the Company’s investments and therefore are unavailable at the time of the close.
Net investment income related to general operations decreased in 2003 as compared to 2002 primarily due to the market decline in yields and the shorter duration of the investment portofolio, partially offset by growth in the investment base.
It is expected that investment income in 2004 will increase moderately due to projected increases in investments resulting from expected positive operating cash flow. However, market changes in interest rates could offset or supplement the effects of cashflow. See further discussion in “Financial Condition and Liquidity”.
Equity in net income of investment affiliates includes earnings from the Company’s investments in closed-end investment funds and partnerships (the alternative investment portfolio) and investment management companies. Equity in net income of investment affiliates increased in 2003 as compared to 2002 due mainly to the strong performance of certain of the Company’s investment funds and investments in management companies, particularly in the second and fourth quarters of 2003 as compared to lower overall returns on these funds and management companies in 2002. In addition, as noted above, income on the alternative investment portfolio was for an eleven month period in 2003 as compared to twelve months in 2002. Equity in net income of investment affiliates in 2002 decreased as compared to 2001 due primarily to lower overall returns in the second and the third quarter of 2002 on certain of the Company’s investment funds as compared to a strong performance of the funds in 2001.
Measurement of investment performance is a function of the investment strategy and business purpose for each of the components of the investment portfolio discussed above. Investment performance is based upon total return of the portfolio that includes net investment income, net realized gains and losses on investments, net realized and unrealized gains and losses on investment derivatives and the change in the net unrealized gains and losses on investments.
Within the actively managed portion of the asset/liability portfolio, the objective is to maximize total investment returns at a risk level that is managed relative to applicable public market fixed income indices. However, the deposit and regulatory holdings portion of the asset/liability portfolio is subject to investment restrictions that limit the effectiveness of active discretionary management. As a result, comparisons of the deposit and regulatory holdings portion of the Company’s asset/liability portfolio with public market indices are not meaningful. Due to the unique nature of the underlying liabilities in the Company’s structured product portfolio (i.e., deposit liabilities and future policy benefit reserves), customized benchmarks are used to measure performance. Finally, certain of the Company’s business investments are private market transactions that cannot be meaningfully compared to certain public indices. Accordingly, only approximately 24% (2002; 40%) of the Company’s total investment portfolio could be meaningfully compared to public market indices. The reduction in comparison to the public market indices is due primarily to sterling portfolios that are now managed relative to custom liability benchmarks.
The table below summarizes investment performance for those portions of the asset/liability and risk asset portfolios that could be meaningfully compared to public market indices for each of the years ending December 31 presented below:
In 2003, all sterling portfolios are now managed relative to custom liability benchmarks. Comparisons to market indices are no longer relevant.
In 2003, the return on the alternative investment portfolio was for eleven months ended November 30, 2003 as compared to twelve months in December 2002 and 2001. The fair market values of certain of these alternative investments often take longer to obtain as compared to other of the Company’s investments and therefore are unavailable at the time of the close. For comparative purposes, the Standard and Poor’s 500 index returns are on the same basis.
For the securities that were sold at a loss during the year ended December 31, 2002, the fair market value of the fixed income securities and equity securities at the sales dates was approximately $8.5 billion and $306.0 million, respectively. For the securities that were sold at a loss during the year ended December 31, 2001, the fair market value of the fixed income securities and equity securities at the sales dates was approximately $8.8 billion and $350.0 million, respectively.
With respect to those securities that were sold at a loss during the year ended December 31, 2002 the following is an analysis of the period of time that those securities had been in an 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:
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors as discussed under “Critical Accounting Policies and Estimates”.
On July 25, 2001, the Company acquired certain Winterthur International insurance operations (“Winterthur International”) to extend its predominantly North American based large corporate business globally. Effective July 1, 2001, the Company’s results include Winterthur International. See Note 6 (b) for additional information. In 2003, the Winterthur International operations changed its name to “XL Global Risk”.
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums written are recorded at the inception of the policy and are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Financial guaranty installment premiums are recorded as premiums written when due.
The Company reviews the fair value of its investment portfolio to identify declines in fair value that are other than temporary. This review involves consideration of several factors including (i) the time period during which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized in the period such determination is made.
The Company recognizes all derivatives as either assets or liabilities in the balance sheet and measures those instruments at fair value. Non-exchange traded weather products are recorded at fair value. The changes in fair value of derivatives are shown in the consolidated statement of income as “net realized and unrealized gains and losses on derivative instruments”. Changes in fair value of derivatives may create volatility in the Company’s results of operations from period to period.
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. Based on the terms and conditions of the agreements, the Company designates the derivative as either a total return swap or a credit derivative. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value.
Short-term investments comprise investments with a remaining maturity equal to or greater than 90 days but less than one year. Equity securities include investments in open end mutual funds.
Certain life insurance and annuity contracts provide the holder with a guarantee that the benefit received upon death will be no less than a minimum prescribed amount. To the extent the guaranteed minimum death benefit exceeds the current account value at the time of death, the Company incurs a cost that is recorded as claims and policy benefits for the period in which the death occurs.
The Company accounts for stock compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”, except for stock options granted subsequent to January 1, 2003. Accordingly, compensation expense for stock awards and stock options issued before January 1, 2003, is recognized to the extent that the fair value of the stock exceeds the exercise price of the option at the measurement date. Stock options issued after January 1, 2003 are accounted for in accordance with FAS 123 “Accounting for stock based compensation” using the fair value based method. See Note 2(r).
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(e), 2(f), 2(g), 7 and 15 for further information.
In January 2003, FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). The objective of FIN 46 is to improve financial reporting by companies involved with variable interest entities. This new model for consolidation applies to an entity in which either (1) the powers or rights of the equity holders do not give them sufficient decision making ability; (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties or (3) the equity investment at risk does not absorb the expected losses or residual returns of the entity. FIN 46 requires a variable interest entity to be consolidated by the company that is subject to a majority of the risk of loss from the variable interest entity’s activities or that is entitled to receive a majority of the entity’s residual returns or both. In December 2003, FASB issued a revision to FIN 46 (FIN 46-R) which clarified several provisions of FIN 46, superceded the related FASB Staff Positions (FSPs), and amended the effective date and transition of the pronouncement, except for certain types of entities. The Company is required to apply the provisions of FIN 46-R to those variable interest entities that are not considered to be special purpose entities no later than March 31, 2004. The Company must apply the provisions of FIN 46 or FIN 46-R to those entities that are consid-
ered to be special-purpose entities as at December 31, 2003. The adoption of this standard did not have a material effect on the Company’s financial condition and results of operations at at December 31, 2003 and is not expected to have a material effect at March 31, 2004. See Note 16 for further information.
Ratios are based on net premium earned from general operations excluding fee income and other. The underwriting
Other insurance and reinsurance premiums written and earned include political risk, surety, bonding, warranty and other lines.
Terrorist attacks at the World Trade Center in New York City, in Washington, D.C. and in Pennsylvania on September 11, 2001 (collectively, “the September 11 event”) are estimated to have caused the largest ever man-made insured losses for the property and casualty insurance industry. The Company has exposure to this event with claims arising mainly from its aviation, property, personal accident and business interruption insurance and reinsurance coverages.
During the second quarter 2002, the Company increased loss reserves by $200.0 million following the receipt of updated loss information. Due principally to the complexity of the claims and inherent lag in reporting from insureds and cedents, management believed it was necessary to increase the estimate for ultimate losses.
During the third quarter 2001, the Company performed a detailed analysis of contracts it believed were exposed to this event. The process varied between segments, due to the specific nature of each of their operations, and by line of business. For the insurance lines of business, the Company was able to identify a limited number of relevant contracts soon after the event. The process included identification of possible claims using underwriting systems to determine potential exposures on a case-by-case basis. The exposures were then analyzed to determine the exact location and magnitude of the potential loss.
At December 31, 2003, net losses and loss expenses comprise gross claims of $1.9 billion with estimated reinsurance recoveries of $1.2 billion, both excluding Winterthur International. Winterthur International incurred gross losses of $272.0 million related to the September 11 event, which the Company expects to recover from third-party reinsurers or under the net loss reserve seasoning mechanism in the Sale and Purchase Agreement (defined in Note 6 (b)), or a combination of the two. These losses related to business written by Winterthur International prior to July 1, 2001.
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, 2003, 2002 and 2001:
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (“Winterthur International”) primarily to extend its predominantly North American based large corporate insurance business globally. The Company provisionally paid to the Seller $405.6 million at closing for Winterthur International based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at December 31, 2000 and the price was subject to final determination based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at June 30, 2001 (the “Completion Financials”). In December 2003, the Company reached an agreement with the Seller as to the final purchase price, which was $330.2 million. As a result, $75.4 million in cash was returned to the Company.
The SPA provides for independent actuarial determination should the Seller and the Company disagree on the final amounts due thereunder. The Company may recognize an impairment if the amount determined to be due to the Company is less than the carrying value of the SPA recovery balance deemed due from the Seller or to the extent that any amount proves to be uncollectible from the Seller for any reason. Certain Winterthur International businesses and product lines were not acquired, primarily asbestos liabilities, certain insurance liabilities in respect of 1985 and prior years, certain captive management, alternative risk and life insurance business.
The revised fair value of significant assets and liabilities acquired by the Company includes $89.4 million of cash, $2.2 billion of invested assets, $1.3 billion of premiums receivable, $1.5 billion of unpaid losses and loss expenses recoverable, $2.8 billion of unpaid losses and loss expenses, $885 million of unearned premiums and $506 million of reinsurance balances payable. The contractual post-closing protection is considered in these fair value estimates.
In the first quarter of 2001, the Company acquired The London Assurance Company of America, Inc., a shell company licensed in forty-five U.S. states, for the purpose of obtaining licenses for the financial guaranty operations of the Company. The cost of the acquisition less cash acquired was $16.5 million. Intangible assets related to the licenses was $11.2 million.
The total amount of an other than temporary decline in value in 2003 related to $68.4 million on fixed income securities, $54.2 million on equity securities and $8.1 million on other investments. Of the decline in value of fixed income and equity securities considered to be other than temporary in 2003, approximately 12% related to investments in the communications sector.
The cost (amortized cost for fixed maturities and short-term investments), market value, gross unrealized gains and gross unrealized (losses) of investments are as follows:
At December 31, 2003, there was $120.0 million of gross unrealized losses on fixed income and short-term investments, and $ 6.2 million of gross unrealized losses on equity securities. At December 31, 2002, there was $141.9 million of gross unrealized losses on fixed income and short-term investments and $86.9 million of gross unrealized losses on equity securities. These losses include certain securities below investment grade. At December 31, 2003, approximately 5.4% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade. Approximately 7.7% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2003 related to securities that were below investment grade and 1.1% of securities were in an unrealized loss position that were not rated.
The information shown below about the unrealized losses on the Company’s investments at December 31, 2003 concerns the potential affect 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.
The following is an analysis of how long each of those securities at December 31, 2003 had been in a continual unrealized loss position:
The Company has invested in certain closed end funds, certain limited partnerships and similar investment vehicles, including funds managed by certain of these investment managers (the “alternative investment portfolio”). The Company has made minority investments ranging from 20% to 33% in several investment managers for which the Company paid a total of $142.0 million. The significant investments include Highfields Capital Management LP, a global equity investment firm, Pareto Partners L.P., a currency overlay and fixed income manager, MKP Capital Management, a fixed income investment manager, specializing in mortgage-backed securities, FrontPoint Partners LLC, an integrated alternative asset firm and Stanfield Capital Partners, a credit based asset management firm. At December 31, 2003, the alternative investment portfolio was $1.4 billion.
The Company’s insurance affiliate investments at December 31, 2003 included Sovereign Risk Insurance, American Strategic Holdings, Sunshine State, and Special Risks Insurance and Reinsurance with ownership in those entities at 49%, 35%,21%, and 18%, respectively.
In certain investments, the carrying value is different from the share of the investee’s underlying net assets. The difference represents goodwill on acquisition. Adoption of FAS 142 with effect from January 1, 2002 has resulted in the Company ceasing to amortize goodwill and certain intangible assets.
The following table presents the net adverse (favorable) development of reserves analyzed by each of the Company’s operating segments:
During 2001, the net favorable prior year loss development of $78 million related principally to the Company’s excess casualty insurance business. 2001 favorable development related to business written in 1994 through 1997. Similar to 2002, favorable development was due primarily to judgment required in establishing reserves for this line of business due to the lack of industry data available as described above.
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 State 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.
As a result of the new information obtained in the claims audit review, the Company changed its actuarial methodology and key assumptions for determining ultimate loss reserves. The Company separately reviewed the historical loss development of its major cedents using several actuarial methodologies; where the analysis of a cedent’s experience concluded that the experience was worse than the Company’s historical loss development experience, the Company projected that cedent’s ultimate loss based on the cedent’s own experience. In addition, the Company assumed that the more recent experience was more indicative of future loss development by selecting development patterns that were based on the most recent experience rather than on the Company’s or cedent’s longer term historical experience.
In the second quarter 2002, the Company increased its estimated loss reserves for the September 11 event by $127 million due primarily to higher than originally estimated business interruption losses and exposure to potential claims by the Lloyd’s Central Guaranty Fund. The increase followed an analysis of additional new information received from the Company’s ceding companies with regard to their increased estimates of claims relating to their exposures to the September 11 event. During 2001, the Company had recorded incurred losses for the September 11 event for its reinsurance operations of $442 million. Due to the size and complexity of the loss and the time lag in ceding companies reporting the information to the Company, establishing reserves for this loss within a short time period was difficult.
The increase in estimate for all other reinsurance reserves in 2002 and 2001 of $258 million and $253 million, respectively, also related principally to losses on business written in 1997 through (and including) 2000 in the Company’s U.S. casualty reinsurance business and for asbestos losses in years prior to 1985. The increase in 2002 was partially offset by decreases in estimates for losses related to business written in 1985 through 1996 in these same lines of business. The increases in 2002 and 2001 were also due to increases in reported claims that were in excess of the Company’s expected loss development for this business from higher court settlement awards. The Company did not change its methodology or key assumptions for determining ultimate loss reserves in 2002 or 2001.
The Company’s net incurred losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2003 and 2002, the reserve for potential non-recoveries from reinsurers was $108.0 million and $47.3 million, respectively.
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, 2003, 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 following table presents an analysis of total unpaid losses and loss expenses recoverable between general, life and annuity, and financial operations for the year ended December 31, 2003:
As at December 31, 2003, the Company had bank, letter of credit and loan facilities available from a variety of sources, including commercial banks, totaling $6.1 billion, (2002: $5.1 billion) of which $1.9 billion (2002: $1.9 billion) of debt was outstanding. In addition, $2.7 billion (2002: $2.5 billion) of letters of credit were outstanding as at December 31, 2003, 8.7%, (2002: 6.5%) 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.
There were no borrowings or repayments under the Company’s revolving credit facilities during 2003. During 2002, borrowings under these facilities were $846.8 million and repayments under the facilities were $600.0 million.
In January 2003, the Company entered into a new $100.0 million letter of credit facility in order to provide additional capacity to support the Company’s U.S. non-admitted business. This facility was subsequently increased to $200.0 million in June 2003 and was fully utilized at December 31, 2003.
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 $2.0 million in 2003 and the liability will continue to be amortized over a ten year term.
Although both the CARZ and LYONs are due to be repaid in 2021, there are several features that may result in the bonds being repaid or converted into the Company’s Class A Ordinary Shares before the redemption date. As these features include market-driven features and options available to the Company and bondholders, it is not possible to determine if the bonds will remain outstanding until their scheduled maturity in 2021.
In addition, each of the CARZ and LYONs provide for a contingent conversion feature that gives the bondholders the right to convert the bonds into the Company’s shares at other times during the life of the bonds if the market price of the Company’s shares is at certain levels. Accordingly, if the Company’s ordinary share price is at least 110% of the accreted conversion price for at least twenty of the thirty days during the relevant conversion period, the bondholders would
have the right to convert the bonds into ordinary Shares. If converted for ordinary shares, each CARZ would be converted into 5.9467 ordinary shares and each holder of a LYONs would receive 5.277 ordinary shares. The accreted values would be determined by applying the accretion rate to the initial issue price. In the example of CARZ, the accreted price on May 23, 2004 will be $641.88 determined by adding three years’ accretion of 2.6422% per annum on an annual basis to the original issue price of $593.57.
These bonds also provide for interest rates to be adjusted in the event that the Company’s ordinary share price falls below levels specified in the relevant indenture relative to the conversion price.
The puts and the interest rate adjustment features embedded in the CARZ and LYONs are considered derivatives and are subject to fair value. There is currently minimal value ascribed to the puts, as the contingent events of these features are considered unlikely to occur or to the interest rate adjustment feature due to the current trading value of the bonds. Due to the contingent nature of the conversion features of these debt securities, there is no impact on fully diluted earnings (loss) per ordinary share at this time.
Each of the LYONs, CARZ and 6.5% Guaranteed Senior Notes indentures contains 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 LYONs and 6.5% Guaranteed Senior Notes indentures. Under the CARZ indenture, in the event that the Company defaults in the payment of indebtedness in the amount of $100.0 million or more, an event of default would be triggered.
The following table summarizes these instruments and the effect on net income in the years ended December 31, 2003, 2002 and 2001:
In order to effectively price and market the transaction, different tranches are modeled for the purpose of assigning credit ratings based upon the level of subordination. Generally, a primary layer is created to enable the originator of the transaction to participate in the risks. The Company generally participates in senior or higher quality rated tranches of a risk, but may participate in the primary layer in very limited instances.
The Company fair values transactions related to the primary layers of credit derivatives using a model that calculates the net present value of the premiums and expected losses based on assumptions regarding interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change in fair value recorded for transactions pertaining to primary layers for the years ended December 31, 2003, 2002 and 2001 was a loss of $28.6 million, a loss of $16.2 million and a gain of $8.1 million, respectively.
The change in fair value recorded for the weather and energy derivatives was a gain of $1.1 million, $16.6 million and $16.6 million for the year ended December 31, 2003, 2002 and 2001, respectively.
At December 31, 2003, contracts designated as fair value hedges were in a $3.2 million net unrealized gain position. As a result of the fair value hedges, deposit liabilities were increased by $3.1 million at December 31, 2003. The ineffective portion of the hedge amounted to $0.1 million as part of net realized gains. The interest rate swap hedges resulted in a reduction in interest expense of $2.6 million for the year ended December 31, 2003.
At December 31, 2002, contracts designated as fair value hedges were in a $1.1 million net unrealized gain position. As a result of the fair value hedges, deposit liabilities were reduced by $0.74 million at December 31, 2002. The ineffective portion of the hedge amounted to $0.06 million and the reduction in interest expense as a result of the hedges amounted to $0.18 million for the year ended December 31, 2002.
The Company holds warrants in conjunction with certain of its other investments. These warrants are recorded at fair value based on quoted market prices. At December 31, 2003, the Company recorded a loss of $3.2 million, and a loss of $16.7 million for 2002. This related to the change in fair value of these warrants. The primary reason for the loss in 2003 and 2002 was the decline in fair value of the Mutual Risk Management Ltd warrants of $3.2 million in 2003 and $11.6 million in 2002.
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
The Company has an investment in the junior notes of a collateralized debt obligation (“CDO”). The Company also issued financial guaranties for the senior notes of the CDO. As of December 31, 2003, the CDO had assets of $463.9 million and liabilities of $395.6 million and the Company’s maximum exposure to loss as a result of its financial guaranties and investment in this variable interest entity was approximately $412.3 million. The Company could experience a loss in the event that the cash flows relating to the underlying assets are not collected as expected. The Company is not the primary beneficiary of this entity and therefore is not required to consolidate this entity.
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 $467.0 million and $403.9 million at December 31, 2003 and 2002 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.
(2) International includes multi-country transactions where there is no majority exposure to any single country.
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, 2003 amounted to $7.2 billion 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.
In addition, the Company underwrites a significant amount of its general insurance and reinsurance business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During 2003, 2002 and 2001, approximately 24%, 23% and 23%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by Marsh & McLennan Companies. During 2003, 2002 and 2001, approximately 17%, 17% and 16%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by AON Corporation and its subsidiaries. Both of these companies are large, well established companies and there are no indications that either of them is financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from general operations in each of the three years ended December 31, 2003.
The Company’s available for sale investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification, which limit the allowable holdings of any single issue. The Company did not have an aggregate investment in a single entity, other than the U.S. government, in excess of 10% of the Company’s shareholders’ equity at December 31, 2003 and 2002.
In connection with its acquisition of Winterthur International in July 2001, in an all cash transaction, the Company has recorded an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $740.9 million at December 31, 2003 based on provisions of the SPA.
The SPA provides the Company with post-closing protection with respect to adverse development of loss and unearned premium reserves relating to the acquired Winterthur International operations. This protection is based upon actual net loss experience and development over a three year post-closing seasoning period based on loss development experience, collectible reinsurance, reinsurance recoveries and certain other factors set forth in the SPA. The SPA provides for independent actuarial determination should the Seller and the Company disagree on the final amounts due thereunder. The Company may recognize an impairment if the amount determined to be due to the Company is less than the carrying value of the SPA recovery balance deemed due from the Seller or to the extent that any amount proves to be uncollectible from the Seller for any reason.
The Company owns a minority interest in certain closed-end funds, certain limited partnerships and similar investment vehicles, including funds managed by those companies. The Company has commitments, which include potential additional add-on clauses, to invest a further $149.9 million over the next five years.
At December 31, 2003 and 2002, $2.7 billion and $2.5 billion of letters of credit were outstanding, 8.7%, (2002: 6.5%) 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. See Note 14 for further information.
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. In June 2000, the Company’s Class B ordinary shares were converted into Class A ordinary shares on a one-for-one basis. All ordinary shares in issue at December 31, 2003 are Class A ordinary shares.
In August 2002, the Company issued 9.2 million 8.00% Series A Preference Ordinary Shares at $25 per share. Gross proceeds were $230.0 million and related expenses were $7.2 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after August 14, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the Preference Shares before August 14, 2007 at specified redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference Shares are entitled to a class vote ($26 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’s long term stock plan, the 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.
Prior to December 31, 2003, all options granted to non-employee directors were granted under the 1991 Performance Incentive Program. In 2004, these options will be granted under the Directors Stock & Option Plan. All options vest immediately on the grant date. Directors may also make an irrevocable election preceding the beginning of each fiscal year to defer cash compensation that would otherwise be payable as his or her annual retainer in increments of 10%. The deferred payments are credited in the form of ordinary share units calculated by dividing 110% of the deferred payment by the market value of the Company’s stock on the date the compensation would otherwise have been paid. These shares are distributed under the terms of the plan. Shares issued under the plan totaled 3,153, 3,622, and 4,240 in 2003, 2002 and 2001, respectively.
Total stock based compensation expensed, which related to amortization of restricted stock, was $17.9 million, $14.3 million, and $10.4 million in 2003, 2002, and 2001, respectively.
The Company maintains both defined contribution and defined benefit retirement plans, which vary for each subsidiary. Plan assets are invested principally in equity securities and fixed maturities.
A qualified non-contributory defined benefit pension plan exists to cover a substantial 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 $23.9 million, $23.9 million and $13.1 million, respectively, as of December 31, 2003, and $20.3 million, $20.3 million and $11.6 million, respectively, as of December 31, 2002.
The related tax effects allocated to each component of the change in accumulated other comprehensive income were as follows:
In 2003 and 2002, the Company paid dividends of $40.3 million and $9.6 million, respectively, to Series A and Series B preference shareholders.
In 2002, four regular quarterly dividends were paid at $0.47 per share to ordinary shareholders of record of February 4, May 28, August 5 and December 2.
Effective as of January 1, 2004, XL Re America Inc (“XLRA”), a member of the U.S. group, entered into an adverse development reinsurance treaty with another non U.S. reinsurance subsidiary of the Company. The treaty related to the 1985 through (and including) 2001 underwriting years covering any adverse development on reserves calculated as of December 31, 2003 between January 1, 2004 and December 31, 2005. The treaty has a limit of $500 million and will limit future loss development at XLRA relating to these underwriting years. Any commutation of this treaty requires the prior approval of the New York Department of Insurance. There is no impact of this treaty on the consolidated financial statements of the Company, however as part of management’s continuing evaluation of its deferred tax asset, the treaty is critical in evaluating the future income position of the U.S. group of companies. Management believes that the treaty will protect the U.S. group from unexpected prior loss development. Absent unexpected loss development from the 2001 and prior underwriting years, management has concluded that there is sufficient positive evidence of future profitability in the U.S. and that a valuation allowance as a charge against the deferred tax asset is not required at this time.
The Company’s ability to pay dividends is subject to certain regulatory restrictions on the payment of dividends by its subsidiaries. The payment of such dividends is limited by applicable laws and statutory requirements of the various countries the Company operates in, including Bermuda, the U.S. and the U.K., among others. Statutory capital and surplus as reported to relevant regulatory authorities for the principal operating subsidiaries of the Company for the years ended December 31, 2003 and 2002 was as follows:
(2) Average stock options of 2,007 outstanding for the year ended December 31, 2001 have been excluded where these were anti-dilutive to the loss per ordinary share.
(1) Certain reclassifications have been made relating to the Company’s change in presentation of financial operations. There was no effect on net income from this change in presentation.