Total rent expense for the years ended December 31, 2004, 2003 and 2002 was approximately $31.4 million, $42.3 million and $30.4 million, respectively. See Item 8, Note 18(d) to the Consolidated Financial Statements for discussion of the Company’s lease commitments for real property.
Net income from investment affiliates in 2003 includes income on the alternative investment portfolio for eleven months ended November 30, 2003 as compared to twelve months in prior years. The fair market values of certain of these alternative investments often take longer to obtain as compared to the other of the Company’s investments and therefore are unavailable at the time of the close.
This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about the Company’s beliefs and expectations, are forward looking-statements. These statements are based upon current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See “Cautionary Note Regarding Forward-Looking Statements” for a list of additional factors that could cause actual results to differ materially from those contained in any forward-looking statement.
The property and casualty insurance and reinsurance markets have historically been cyclical, meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable (a “hard market”) to the Company and there have been periods where premium rates decline and policy terms and conditions are less favorable (a “soft market”) to the Company. This has been driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events. Management’s goal is to build long-term shareholder value by capitalizing on current opportunities and managing through any potential downward cycles by reducing its property and casualty book of business and exposures if and when rates deteriorate to unprofitable levels for the Company. As part of its long-term strategy, the Company also looks to its financial products and services segment to provide a diversified stream of earnings that are not directly tied to the property and casualty cycle. In this regard, the Company’s financial guaranty operations have substantially achieved relative trading parity with its peers.
The Company has grown through acquisition activity and development of 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 guaranty 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 3,500 employees in 29 countries.
The Company earns its revenue primarily from net premiums written and earned. Premium rates in the property and casualty industry began to increase in 2001 following five years of poor underwriting performance in the industry. These price increases were further compounded by the September 11 event. In the three years ended December 31, 2003, the Company experienced pricing increases and improved terms and conditions across most of the lines of business it writes. These generally, across-the-board price increases were unprecedented meaning that, in the past, pricing increases and more favorable terms and conditions were not experienced across all of the Company’s product lines at one point in any one cycle.
Property and casualty market conditions overall remain attractive although price competition continued to increase throughout 2004, most notably in regards to property and professional lines. Accordingly, the Company continued to focus on disciplined risk selection. Based on continued solid demand and the benefits of price increases and improved terms achieved over the last several years’ renewals, the Company believes that overall business in the insurance and reinsurance markets was adequately priced. In relation to insurance and reinsurance, with respect to current market conditions and January 1, 2005 renewals, the Company has seen competitive pressures continue. The impact of the 2004 storm season, the backdrop of continued emergence of adverse development related to the market of the late 1990’s and concerns about reinsurer financial strength, all served to reinforce a sense of discipline in the market. Marine rates were flat to down 10%, energy rates were up 10 to 15% reflecting the substantial impact of Hurricane Ivan. Casualty rates appear to have remained flat on average. In accordance with this increasingly competitive market environment, the Company’s expectation is for flat earned premium growth for full year 2005, with insurance flat to up low-single digits and reinsurance flat to down low single-digits.
For the three years up to December 31, 2003, there were declines in interest rates that negatively impacted the Company’s net investment income. The Company expects net investment income to rise in 2005 supported by positive cash flow from operations and anticipated moderate increases in market interest rates.
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. Changes in the Company’s combined ratio for the last three years have been negatively impacted by the net losses incurred, related to 2004 catastrophe activity and prior period development in all three years. The improvement in 2004 was primarily a result of the severity of the prior period development in 2003 offset by the catastrophe losses noted in 2004.
Management continues to focus heavily on the Company’s financial strength and claims paying ratings because the Company’s ability to write business is dependent upon the quality of these ratings. Management seeks to maintain strong financial strength and claims paying ratings, relative to its competitors. In January 2004, several internationally recognized agencies lowered their financial strength ratings at the Company’s principle insurance and reinsurance subsidiaries and pools following the announcement that the Company increased prior period reserves in the fourth quarter of 2003. In February 2005, Fitch placed the Company’s financial strength and claims paying ratings on Rating Watch Negative and Moody’s confirmed the Company’s ratings and changed the outlooks to Negative.
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, 2004 generated from its underwriting activities (premiums less claim and expense settlements) as well as the receipt of investment income on its portfolio. The Company expects cash flow from operations to be strong in 2005.
The following table presents an analysis of the Company’s net income available to ordinary shareholders and other financial measures (described below) for the years ended December 31, 2004, 2003 and 2002:
3) Growing asset base and positive performance from investments in affiliates;
1. Significant large catastrophe activity in 2004. (Florida hurricanes and the Tsunami in South Asia)
Net adverse prior year 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 year loss development in 2004 related to the Company’s general insurance operations most notably in the casualty and professional lines of business.
During 2004, the Company’s net adverse prior year development of $268 million was a result of increases in reported insurance case reserves for excess professional liability, excess casualty liability and specialty lines within the insurance segment offset by net prior year releases in the reinsurance segment. These increases in reported insurance case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Strengthening of $144 million in professional lines was caused by few large directors’ and officers’ claims in pre-2002 business, and increases in errors and omissions reserves were caused by claims related to large accounting firms and to insurance/reinsurance brokers. For specialty lines, strengthening of $135 million was caused by reported loss increases in discontinued programs business with workers’ compensation exposure, environmental related coverages, and Lloyd’s; as well as high severity claims on the surety book.
See further discussion under “Critical Accounting Policies and Estimates” and under “- Segments-Reinsurance” below.
The Company realized losses on securities in its investment portfolio due to declines in fair value determined to be other than temporary of $6.4 million, $130.7 million and $251.5 million for the years ended December 31, 2004, 2003 and 2002, respectively.
See the discussion of other than temporary declines in investments within “Critical Accounting Policies and Estimates” and “Investment Activities” below.
As the Company earns premiums for the underwriting risks it assumes, it also establishes an estimate of the expected ultimate losses related to the premium. Loss reserves or unpaid losses and loss expenses are established due to the significant periods of time that may lapse between the occurrence, reporting and settlement of a loss. The process of establishing reserves for unpaid property and casualty claims can be complex and is subject to considerable variability as it requires the use of informed estimates and judgments. These estimates and judgments are based on numerous factors, and may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Loss reserves include:
IBNR reserves are calculated by the Company’s actuaries using standard actuarial methodologies as discussed above. Prior to the year ended December 31, 2003, the outcomes of the Company’s actuarial reviews, consistent with historical practice, provided either (i) a single point reserve estimate or (ii) a range of reserve estimates from which the Company selected a best estimate. Since the year ended December 31, 2003, the Company adopted a methodology that provided a single point reserve estimate separately for each line of business and also a range of possible outcomes across each single point reserve estimate. This is discussed further below. As a result, reserve ranges disclosed previously are not comparable to the reserve ranges disclosed herein.
While the proportion of unpaid loss and loss expenses represented by IBNR is sensitive to a number of factors, the most significant ones have historically been accelerating business growth and changes in business mix. Other factors which have affected the ratio in the past include; additions to prior period reserves, catastrophic occurrences, settlement of large claims and changes in claims settlement patterns.
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, 2004 and 2003 were 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, 2004:
Other consists of several products, including accident and health, political risk, surety and bonding.
Actual development of recorded reserves as of December 31, 2003 during 2004 was within the estimated reserve range.
As shown in the table above and as previously noted, for the year ended December 31, 2004 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.
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 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.
The Company does not calculate a range for its total net unpaid loss and loss expense reserves as it would not be appropriate to add the ranges for each line of business to obtain a range around the Company’s total reserves because this would not reflect the diversification effects across the Company’s various lines of business. The diversification effects result from the fact that losses across the Company’s different lines of business are not completely correlated.
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 attaches 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 has increased. As a result, the Company has obtained a larger statistical base to assist in establishing reserves for these excess casualty insurance claims.
Casualty reinsurance business involves reserving methods that generally include historical aggregated claim information as reported by ceding companies, combined with the results of claims and underwriting reviews of a sample of the ceding company’s claims and underwriting files. Therefore, the Company does not always receive detailed claim information for this line of business.
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.
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. Due to the size of the gross losses arising from the September 11 event and its effect on the reinsurance industry, the Company, in addition to its normal review process, further analyzed the recoverability of these assets. In addition to the potential effect of the non-recoverability of these assets from reinsurers disputing claims, the reinsurance market in general has experienced significant capital erosion as a result of underwriting and investment losses. Accordingly, there is greater uncertainty regarding recoverability due to the reinsurers’ ability to pay. See “Financial Condition and Liquidity” and Item 8, Note 10 to the Consolidated Financial Statements for further information.
Included in unpaid loss and loss expenses recoverable at December 31, 2004 is an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (the “Seller”) of $1.45 billion, related to certain contractual arrangements with the sale and purchase agreement, as amended (“SPA”) from the Company’s acquisition of Winterthur International in July 2001. The Seller is currently rated “A-” by S&P. The Seller provides the Company with post-closing protection determined as of June 30, 2004 with respect to, among other things, adverse development of net loss and unearned premium reserves relating to the acquired Winterthur International business (“Winterthur Business”). This protection is based upon net loss experience and development over a three-year, post-closing season-
ing period based on actual loss development experience, collectible reinsurance and certain other factors set forth in the SPA. The SPA includes a process for determining the amount due from the Seller by an independent actuarial process whereby the independent actuary develops a value of the seasoned net reserves. The actual final seasoned amount will be the submission that is closest to the number developed by the independent actuary.
As the Company and the Seller were unable to come to an agreement, the Company submitted to the Seller notice to trigger the independent actuarial process as contemplated by the SPA. On February 3, 2005, both the Company and the Seller made submissions for the independent actuarial process. The Company’s submission would result in a net payable to the Company of approximately $1.45 billion in aggregate and the Seller’s submission would result in a net payable to the Company of $541 million in aggregate. At the completion of the independent actuarial process, the Company will be entitled to a lump sum payment.
2. Under two retrocession agreements the Company has reinsurance protection on the remaining portion of reinsurance recoverables with respect to incurred losses seasoned 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.
(i) The Seller’s submission is closer to the valuation developed by the independent actuary and, as such, the Seller’s submission is the actual final seasoned amount;
(ii) There is deterioration of the net losses from what is reported in the Company’s December 31, 2004 financial statements;
(iii) The Company is unable to make full recovery of the reinsurance recoverables related to the Winterthur Business, either from third parties or from the Seller under the additional protections; or
(iv) Any amount due from the Seller proves to be uncollectible from the Seller for any reason.
The Company also provides reinsurance of disability income protection. The future policy benefit reserves for these contracts amounted to $86 million and $89 million at December 31, 2004 and 2003, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of “padded” assumptions at inception with periodic review against experience. The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide an income if the policyholder becomes sick or disabled. The liabilities are therefore driven mainly by the rates at which policyholders become sick (where sickness is defined by the policy conditions) and by the rates at which these policyholders recover or die. A 1% increase in the incidence rate would increase the value of future claims by approximately $0.1 million, while a decrease in the termination rate would increase the value of future claims by approximately $0.4 million.
Following a review of lapse experience, the locked-in assumptions were revised in respect of one contract during the year ended December 31, 2004. The overall affect of using the revised assumptions was a reduction in income of $0.4 million.
The Company enters into credit derivatives in connection with its financial guaranty business and the Company intends to hold these contracts to maturity. In determining fair value, management differentiates between investment and non-investment grade exposures and models them separately. Management estimates fair value for investment grade exposures by monitoring changes in credit quality and selecting appropriate market indices to determine credit spread movements over the life of the contracts. The determination of the credit spread movements is the basis for calculating the fair value. For credit derivatives that are non-investment grade and therefore do not have a readily determinable market value, the Company uses an alternative fair value methodology. The fair value is determined using a cash flow model developed by the Company and is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. Installment premiums are also considered in the determination of discounted net cash flows. Other elements of the change in fair value are based upon pricing established at the inception of the contract. Changes in fair value are unrealized as the credit derivatives are not traded to realize this value. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis.
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) 2000 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 2000 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 Statements.
Intangible assets are carried at or below estimated fair value. There are many assumptions and estimates underlying the fair value calculation. Principally, the Company identifies the business entity that the intangible asset is attributed to, reviews historical and forecasted performance and other underlying factors affecting such analysis, including market conditions, premium rates and loss trends. Other assumptions used could produce a significantly different result which may result in a change in the value of the intangible asset and related amortization charge in the Consolidated Statement of Income. Based on the current expectations of profitability, an impairment charge would only be recognized in the event of a significant decline in the expected profitability of those operations where such intangible assets are applicable. At December 31, 2004, intangible assets were $1.8 billion of which approximately $1.38 billion and $450 million related to the Company’s reinsurance and insurance segments, respectively. See “- Other Revenue and Expenses” for further information.
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.
The company writes business on both an excess of loss and proportional basis. In the case of excess of loss contracts, the subject written premium is generally outlined within the treaty and the Company receives a minimum and/or deposit premium on a quarterly basis which is normally followed by an adjustment premium based on the ultimate subject premium for the contract. The Company estimates the premium written on the basis of the expected subject premium and regularly reviews this against actual quarterly statements to revise the estimate based on the information provided by the cedant.
On proportional contracts, written premiums are estimated to expected ultimate premiums based on information provided by the ceding companies. An estimate of premium is recorded at the inception of the contract. When the actual premium is reported by the ceding company, normally on a quarterly basis, it may be materially higher or lower than the estimate. Adjustments arising from the reporting of actual premium by the ceding companies are recorded in the period in which they are determined.
Increases in gross and net premiums written in 2003 as compared to 2002 were due to significant price increases across most lines of business, partially offset by the non-renewal of certain workers’ compensation and Lloyd’s international programs.
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 $248.3 million in the property and marine lines combined with prior year reserve strengthening as discussed below, and losses and loss expenses related to the tsunami in South Asia. Losses due to hurricanes Charley, Frances, Ivan and Jeanne combined with the South Asia Tsunami increased the loss ratio for the year by 7.5%.
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 which was partially offset by a relatively lower level of current year loss activity and the positive effect of continued pricing increases and improved terms and conditions across most lines written.
increases in discontinued programs business with workers compensation exposure, environmental related coverages, certain Lloyd’s business and high severity claims on the surety book.
The following table summarizes the underwriting results for the general operations of this segment:
Gross premiums written increased slightly for the year ended December 31, 2004 as compared to 2003. Most lines of business remained relatively flat as a result of rate decreases being offset by selective new premium volume growth. Casualty rates have remained stronger than the shorter tail lines of business. The high frequency of catastrophic events prompted some stabilization of rates in the property catastrophe business most impacted by the losses, namely in Florida, in the latter half of the year. In addition, the increasingly competitive market has resulted in the non-renewal of certain Latin American property programs. Favorable foreign exchange movements also contributed $107.3 million to the growth in gross premiums written. Net premiums written reflect the above gross changes, together with higher retentions, offset by the effects of retrocessional reinstatement premiums and growth in certain large proportional programs that are largely retroceded.
Gross premiums written increased 7.2% in 2003 as compared to 2002 due mainly to new business written and increases in premium rates, primarily in casualty. These increases were partially offset by some cancellations in treaty renewals in 2003 and also a reduction of $18.0 million in 2003 attributable to reinstatement premiums related to the release of loss reserves for the September 11 event, discussed further below.
Net premiums earned in 2004 increased 18.8% as compared to 2003 and net premiums earned in 2003 increased 18.1% as compared to 2002 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 and $792.6 in 2002.
The loss and loss expense ratio includes net losses incurred for both the current year and any adverse or favorable prior year development of loss reserves held at the beginning of the year.
During 2003, the Company increased its estimated reserves related to its reinsurance segment (excluding the September 11 event) by $996 million, of which approximately $877 million related primarily to the Company’s North American reinsurance operations for casualty business underwritten during the 1997 through 2001 underwriting years. The main lines of business affected by this adverse development included general liability, medical malpractice, professional and surety lines. This adverse development was due to competitive market pressures on pricing during these underwriting years combined with 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. Prior year reserves also developed adversely on certain other casualty business written in the 1998 through 2001 underwriting years outside of North America. These exposures were affected by trends similar to those as described above for the North American casualty reinsurance operations. The casualty exposures underwritten in these entities were much less than those of the North American operations, so the impact on the prior year reserves was relatively smaller.
The increase in estimate for all other reinsurance reserves in 2002 of $258 million 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 on business written prior to 1985.
Incurred but not reported losses, net of reinsurance, included in the above table was $22.5 million at December 31, 2004, $27.0 million at December 31, 2003 and $33.1 million at December 31, 2002. Unpaid losses recoverable are net of potential uncollectible amounts.
2. Fourth quarter of 2003 - two portfolios, one U.K. and one European, for a total of approximately $395.5 million in net premiums earned and related claims and policy benefits.
Excluding these large contracts, net premiums earned in life and annuity reinsurance increased in 2004 compared with 2003 and 2003 compared with 2002 as the Company expanded its life and annuity reinsurance operations in Europe combined with additional regular premium term assurance contracts written in 2003 which generated further premiums written in 2004.
Acquisition costs, operating expenses and net investment income have increased in line with the expansion of this business. 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.
In 2003, the Company reclassified all credit derivatives from the general operations insurance segment into the financial products and services segment. Prior period information has been reclassified to conform to current year presentation. There was no net income impact of this change in presentation.
Gross and net premiums written primarily relate to the financial guaranty line of business and reflect premiums received and accrued for in the period and do not include the present value of future cash receipts expected from installment premium policies written in the period. Decreases in gross and net premiums written of 12.1% and 14.6%, respectively, in the year ended December 31, 2004, as compared to the same period in 2003, were primarily due to the combination of conscious underwriting discipline during generally weaker market conditions and a smaller amount of
Net premiums earned also primarily relate to the financial guaranty line of business. Premiums written on such business are earned over the life of the insured debt obligations based on par amount of risk outstanding. Accordingly, as the in force business grows, so will the level of premiums earned from period to period. The increase in net premiums earned in 2004, as compared to the prior year, is 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 associated with an insured project financing structure on which a full limit loss was recognized during the year (see discussion below regarding “Net losses and expenses” for further details). This increase was partially offset by the impact in earned premiums in 2003 related to the refunding of certain insured structures and certain short term contract enhancements not repeated in 2004. The increase in net premiums earned in 2003 as compared to 2002 was primarily due the growth in the financial guaranty in force book of business Premiums earned do not include premiums from the issuance of credit default swaps, which are derivative contracts. Such contracts are reported at fair value and changes therein are included in “Net realized and unrealized gains (losses) on credit derivatives” (see discussion below regarding “Net realized and unrealized gains (losses) on credit derivatives” for further details).
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. Net losses and loss expenses in 2004 increased by 116.5% compared to 2003. The increase was primarily the result of a provision for losses of approximately $41.7 million, representing the present value of a $50.0 million loss relating to the subordinate layer of an insured project financing structure, as well as a net increase in reserves resulting from the growth in the financial guaranty in force business. Management continues to monitor its loss exposures and will revise its loss estimates as necessary, as additional information becomes available.
The Company commenced writing financial guaranty business in 1998 and had relied entirely upon industry data to establish reserves until the end of 2001. In 2002, the Company refined its assumptions to take into account its actual historical loss experience and revised its estimated claim reporting pattern. The Company uses this expected loss reporting pattern, combined with changes in known losses, to determine the prior year development amount. Using the new methodology developed in 2002, actual reported loss development was less than expected in 2004 and 2003, resulting in a release of prior period reserves of $10.5 million and $15 million. In 2002, reported losses for this business were also less than expected and the refinement in assumptions resulted in a decrease in the estimate of reserves for prior years of $13 million.
In the year ended December 31, 2004 acquisition costs decreased compared with the prior year reflecting a change in the average life of the financial guaranty in force book of business over which such costs are expensed. Acquisition costs increased in 2003 as compared to 2002 in line with the growth of the business.
Operating expenses increased in 2004 as compared to 2003, and in 2003 as compared to 2002, due to the investment in segment infrastructure over the last year as well as an increase in the allocation of certain corporate expenses.
Net income from financial affiliates decreased in 2004, as compared to 2003, due primarily to the Company’s investment in Primus Guaranty Ltd. Primus specializes in providing credit risk protection through credit derivatives. Primus had a mark-to-market adjustment in the year which was less favorable than that recorded in the 2003. This decrease was partially offset by income from the sale of a portion of the Company’s investment in Primus, in connection with its Initial Public Offering. Net income from financial affiliates increased in 2003, as compared to 2002, due primarily to increased earnings from the Company’s investment in Primus. These increased earnings were due to a significant narrowing of credit spreads in the second and third quarters of 2003 relative to spreads when the protection was originally sold.
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 increase in minority interest in 2003, as compared to 2002 was due to an increase in the profitability of XL Financial Assurance Ltd.
The Company’s credit derivative transactions relate primarily to financial guaranty coverage that is written in swap form and pertain to tranches of collateralized debt obligations and asset backed securities. The net realized and unrealized gains during the year ended December 31, 2004 relate to the fair value adjustments for transactions written in derivative form, as well as the premiums earned associated with these transactions. These gains, which were mainly unrealized, related to the improvement of credit quality for certain credit pools and were partially offset by several individual credit events in the year. During 2003 and 2002, the opposite conditions existed and the fair value change was negative. The Company continues to monitor its credit exposures and adjust the fair value of these derivatives as required.
Gross and net premiums earned, claims and policy benefit reserves and acquisition costs relate to certain blocks of U.S based term life mortality reinsurance business written that were novated to the Company from an insurance affiliate in December 2002. 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 the significant increase in net premiums earned and claims and policy benefits in 2004 compared to 2003. In 2004, approximately $7.0 million in additional claims and policy benefit reserves were recorded related to this block of business due to adverse claim experience.
Net investment income and interest expense relate to municipal reinvestment contracts and funding agreement transactions. The increase in investment income and the related interest expense were due to the initiation of the fund-
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, 2004.
For a summary of realized and unrealized gains and losses on all derivative instruments, see Item 8, Note 14 to the Consolidated Financial Statements.
The Company’s total investments available for sale and cash and cash equivalents less net pending payable for investments purchased was $23.1 billion at December 31, 2003 as compared to $18.1 billion at December 31, 2002. This increase of $5.0 billion includes (i) cash flow from operations of $3.4 billion and (ii) cash flow of $1.5 billion from spread product transactions. The annualized effective yield of the total investment portfolio was 3.5% for 2003 as compared to 4.3% for 2002, a 0.8% decrease.
It is expected that net investment income in 2005 will increase due to projected increases in investments resulting from expected positive operating cash flow and growth in structured and spread balances, as well as anticipated increases in market yields on reinvestment of existing assets and investment of new cash flows. However, actual market changes in interest rates could offset or supplement the effects of cash flow. See further discussion in “Liquidity and Capital Resources.”
performance of certain of the Company’s investment funds, particularly in the second and fourth quarters of 2003 as compared to lower overall returns on these funds in 2002. In addition, as noted above, income on the alternative investment portfolio was for an eleven month period in 2003 as compared to a twelve months period in 2002.
The Company manages its investment grade fixed income securities using an asset/liability management framework. Due to the unique nature of the underlying liabilities, customized benchmarks are used to measure investment performance and comparison to standard market indices is not meaningful. However, the risk asset portfolios managed by the Company may be compared to appropriate market indices. Investment performance is not monitored for certain assets primarily consisting of operating cash and special regulatory deposits. The following is a summary of the investment portfolio returns for each of the two years ended December 31, 2004 and 2003 of the general account asset/liability portfolio, structured and spread product portfolio and risk asset
Performance on the alternative portolio in 2004 reflects the 12 months to November 30, 2004, as compared to the 11 months ended November 30, 2003 in 2003.
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, 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. During the year ended December 31, 2003, the Company realized losses of $20.9 million and $4.7 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, 2002, the Company realized a loss of $38.4 million and $7.2 million upon the sale of fixed income securities and equity securities, respectively, that had been in an unrealized loss position for greater than twelve months. 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).
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 5 for additional information. In 2003, the Winterthur International operations changed its name to “XL Global Risk”.
In 1999, XL Capital Ltd merged with NAC Re Corp (“NAC”), a Delaware corporation. NAC was organized in 1985 and wrote property and casualty insurance and reinsurance in the U.S., Canada and Europe.
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.
Premiums are earned on a pro-rata basis over the period the coverage is provided. Financial guaranty insurance premiums are earned pro rata to the amount of risk outstanding over the life of the exposure. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force. Net premiums earned are presented after deductions for reinsurance ceded, as applicable.
Acquisition costs, which vary with and are 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.
The Company reviews the fair value of its investment portfolio on a periodic basis to identify declines in fair value below the carrying 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 fair value below carrying value, (ii)
The Company uses derivative instruments to manage duration and foreign currency exposure for its investment portfolio.
The Company accounts for its other investments which do not have readily determinable market values at estimated fair value as it has no significant influence over these entities. The net unrealized appreciation or depreciation on investments, net of tax, is included in “accumulated other comprehensive income/(loss).” Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
Assets and liabilities of foreign operations whose functional currency is not the U.S. dollar are translated at prevailing year end exchange rates. Revenue and expenses of such foreign operations are translated at average exchange rates during the year. The net effect of the translation adjustments for foreign operations, net of applicable deferred income taxes, is included in “accumulated other comprehensive income (loss).”
Intangible assets with an indefinite life and goodwill are no longer amortized with effect from January 1, 2002, in accordance with FAS 142. The Company continues to review the carrying value of goodwill related to all of its investments for any impairment at least annually. If it is determined that an impairment exists, the Company adjusts the carrying value of goodwill to fair value. The impairment charge is recorded in income in the period in which it is determined. See Note 5 for further information.
Certain workers’ compensation, long term disability liabilities and financial guaranty case reserve contracts are considered fixed and determinable and are subject to tabular reserving. Reserves associated with these liabilities are discounted.
For the Company’s financial guaranty reserves, a case basis reserve for unpaid losses and loss adjustment expenses is recorded at the net present value of an estimated loss when, in management’s opinion, the likelihood of a future loss on a particular insured obligation is probable and determinable at a balance sheet date. The Company also maintains an unallocated reserve on its financial guaranty business which is based actuarial reserving analysis. This reserve is available to be applied to new case basis reserves that may be established for claims on current outstanding insured principal and interest in the future. This non-specific reserve is established for expected levels of losses associated with currently insured issues and is based on a portion of premiums earned to date. The Company, on an ongoing basis, monitors these reserves and may periodically adjust such reserves based on the Company’s actual loss experience, its future mix of business, and its view of future economic conditions.
Contracts entered into by the Company with cedants 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 deposit accretion rate is the rate of return required
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 deferral of tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts and the period for which losses may be carried forward. A valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. The Company continues to evaluate income generated in future periods by its subsidiaries in jurisdictions in determining the recoverability of its deferred tax asset. If it is determined that future income generated by these subsidiaries is insufficient to cause the realization of the net operating losses within a reasonable period, a valuation allowance is established at that time.
Disclosure” for options and employee stock purchase Plan shares granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for these plans under the disclosure-only provisions of FAS 123 and no stock based employee compensation cost was included in net income as all options granted had an exercise price equal to the market value of the Company’s ordinary shares on the date of grant. Awards under the Company’s stock plans vest over periods ranging from three to four years. If the fair value based method had been applied to all awards since the original effective date of FAS 123, the cost related to employee stock based compensation included in the determination of net income would have been higher. FAS 148 amends FAS 123 by providing alternative methods of transition for a voluntary change to the fair value-based method of accounting for stock-based employee compensation. In addition, FAS 148 amends the disclosure requirements of FAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.
The following table illustrates the net effect on net income and earnings per ordinary share if the fair value method had been applied to all outstanding and unvested awards for each of the three years ended December 31, 2004; 2003 and 2002:
In April 2004, the FASB issued Staff Position No. FAS 129-1, “Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities” (“FSP FAS 129-1”). The purpose of FSP FAS 129-1 is to interpret how the disclosure provisions of Statement 129 apply to contingently convertible securities and to their potentially dilutive effects on earnings per share. The Company provided the required disclosures related to its contingently convertible securities that are required by FSP FAS 129-1 in its December 31, 2003 financial statements. The contingently convertible securities have been fully redeemed as of December 31, 2004.
In June 2004, the FASB issued Staff Position No. FAS 97-1, “Situations in Which Paragraphs 17(b) and 20 of FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses From the Sale of Investments, Permit or Require Accrual of an Unearned Revenue Liability” (“FSP FAS 97-1”). FSP FAS 97-1 clarifies whether it is appropriate to recognize an unearned revenue liability to compensate the insurer for services to be performed over future periods when future profits are expected to decline from the current level, or only when current profits are expected to be followed by future losses (consistent with SOP 03-1). The adoption of this FSP FAS 97-1 did not have a material effect on the Company’s financial condition or results of operations.
In September 2004, the EITF reached a conclusion regarding Issue No. 04-8, Accounting Issues Related to Certain Features of Contingently Convertible Debt and the Effect on Diluted Earnings per Share (“EITF 04-8”), that contingently convertible securities should be included in diluted earnings per share in all periods regardless of whether the contingency is met and regardless of whether the market price contingency is substantive. EITF 04-8 is effective for reporting periods ending after December 15, 2004. Prior period earnings per share amounts presented for comparative purposes must be restated unless (i) the securities are settled in cash before the end of the effective reporting period in which the consensus is first applied or (ii) the agreement is amended such that the entire contract must be settled in cash. In November 2004 the Zero Coupon Convertible Debentures (“CARZ”) were redeemed and, therefore, EITF 04-8 does not have any effect on the Company’s diluted earnings per share.
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 the beginning of the first interim or annual reporting period that begins after June 15, 2005. 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 will reduce net operating cash flows and increase net financing cash flows in periods after adoption.
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”) and 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. 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) until further guidance is provided by the SEC or FASB. The Company had reserves for financial guaranty insurance contracts of $120.2 million and $62.0 million at December 31, 2004 and 2003, respectively.
Reinsurance general business written includes treaty and facultative reinsurance to primary insurers of casualty and property risks, principally: general liability; professional liability; accident and health; automobile and workers’ compensation; commercial and personal property risks; specialty risks including fidelity and surety and ocean marine; property catastrophe; property excess of loss; property pro-rata; marine and energy; aviation and satellite; and various other reinsurance to insurers on a worldwide basis. The Company’s reinsurance life business is primarily European term assurance, group life, critical illness cover, immediate annuities in payment and disability income business.
Ratios are based on net premium earned from general operations excluding fee income and other. The underwriting expense ratio excludes exchange gains and losses.
This includes net realized gains on investments of $120.2 million and net realized and unrealized losses on
The following tables summarize the Company’s net premiums earned by line of business:
The increase in goodwill in 2003 related primarily to the settlement of the purchase price for Winterthur International (see note 5). As at December 31, 2004 goodwill and intangible assets related to the insurance segment was $450.0 million, the reinsurance segment was $1.38 billion and the financial products and services segment was $4.6 million.
Pro forma financial information and condensed balance sheet information are not presented for the acquisition of XL Re Europe because the results of XL Re Europe’s operations are not significant to the consolidated balance sheet or consolidated results of operations of the Company.
Included in unpaid loss and loss expenses recoverable at December 31, 2004 is an unsecured reinsurance recoverable from the seller of $1.45 billion, related to certain contractual arrangements with the sale and purchase agreement, as amended (“SPA”) relating to the Company’s acquisition of Winterthur International in July 2001. The Seller is currently rated “A-” by S&P. The Seller provides the Company with post-closing protection determined as of June 30, 2004 with respect to, among other things, adverse development of reserves and premium relating to the acquired Winterthur International business (“Winterthur Business”). This protection is 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 includes a process for determining the amount due from the Seller by an independent actuary process whereby the independent actuarial 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 the Seller were unable to come to an agreement, the Company submitted to the Seller notice to trigger the independent actuarial process as contemplated by the SPA. On February 3, 2005, both the Company and the Seller made submissions for the independent actuarial process. The Company’s submission would result in a net payable to the Company of approximately $1.45 billion in aggregate and the Seller’s submission would result in a net payable to the Company of $541 million in aggregate. Approximately $855 million of the total $909 million dollar difference between the Seller and the Company relates to seasoned losses, the remainder relates to premium seasoning. At the completion of the independent actuarial process, the Company will be entitled to a lump sum payment.
At the time of the Winterthur International acquisition, the seller provided a liquidity facility to the Company. At the time of the payment of the net reserve seasoned amount as described above. The Company has the right to repay up to the balances outstanding on this facility by assignment to the Seller of an equal amount of receivables relating to reinsurance recoverables selected by the Company. The payable balance related to this facility is included within other liabilities on the Company’s balance sheet at December 31, 2004 and amounted to approximately $281 million at that date.
Under two retrocession agreements the Company has reinsurance protection on the remaining portion of reinsurance recoverables to the extent that the Company does not receive payment of such amounts from applicable third party reinsurers.
The Company may record a loss in future periods if any or some of the following occur:
There is deterioration of the net losses from what is reported in the Company’s December 31, 2004 financial statements.
Any amount due from the Seller proves to be uncollectible from the Seller for any reason.
ment of the final purchase price in December 2003, the Company has finalized its allocation of the purchase price to the fair value of the acquired tangible net assets based on additional information now available. This information primarily related to loss reserves, adjustment and reinstatement premiums, reinsurance balances payable and receivable and other assets and liabilities. Once the final excess purchase price was known, the Company amended the amount attributed to goodwill by $171.0 million. This settlement of the purchase price and related adjustments represents the completion of the Company’s allocations to the fair value of net assets. Any subsequent adjustments to the carrying value will be reflected in income in the year in which the adjustments are made.
In the first quarter of 2002, the Company acquired Lyndon Life Insurance Company, a shell company licensed to conduct life insurance business in forty-nine U.S. states, for the purpose of obtaining licenses for the Company’s life operations. The cost of the acquisition was $13.5 million, paid in cash in April 2002, and intangible assets arising from the acquisition were $3.5 million. No goodwill was recorded on this acquisition. Lyndon Life Insurance Company has been renamed XL Life Insurance and Annuity Company.
The Company experienced a larger reduction in the amount of write downs for securities with declines in value deemed to be other than temporary than the decline in general defaults. As a percentage of the total fixed income portfolio, the write down for other than temporary declines was negligible in 2004 as compared with 0.6% in 2003.
At December 31, 2004, there were $119.7 million of gross unrealized losses on fixed income and short-term investments, and $7.2 million of gross unrealized losses on equity securities. At December 31, 2003, there were $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, 2004, approximately 4.6% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. At December 31, 2003, approximately 5.4% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. Approximately 5.8% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2004 related to securities that were below investment grade or not rated. The information shown below about the unrealized losses on the Company’s investments at December 31, 2004 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, 2004 had been in a continual unrealized loss position:
At December 31, 2004 and 2003, approximately $463.2 million and $322.4 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, 2004 and 2003 are detailed below.
The Company’s investment in affiliates and equity in net income (loss) from such affiliates are summarized below:
During 2004 the Company recorded other than temporary declines in the values of Insurance Vianet and Venturion Noodle LLC. of $19.0 million and $2.0 million, respectively. The net loss from insurance affiliates in 2003 included an other than temporary decline of $40.9 million in the first quarter of 2003 in the value of the Company’s investment in Annuity & Life Re (Holdings), Ltd. (“ANNRF”). The investment was written down to its fair market value. In the fourth quarter of 2002, the Company wrote down $13.3 million of its investment in ANNRF due to a significant decline in the book value of ANNRF.
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 were caused by large accounting firms and exposure to
During 2002, the Company’s net adverse prior year development of $28 million was comprised of an increase in loss reserves of $73 million relating to the September 11 event that was partially offset by a net decrease in the other reserves of $45 million.
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.
The Company commenced writing financial guaranty business in 1998 and had relied entirely upon industry data to establish reserves until the end of 2001. The Company takes into account its actual historical loss experience and revised its estimated claim reporting pattern for the unallocated losses that the Company records during each loss year. The Company uses this expected loss reporting pattern, combined with changes in reported losses, to determine the prior year development amount. Using this new methodology actual reported loss development was less than expected in 2004 and 2003, resulting in a release of prior period reserves of $10.5 million and $15.0 million. In 2002, reported losses for this business were also less than expected and with the refinement in assumptions resulted in a decrease in the estimate of reserves for prior years of $13 million.
The Company’s net unpaid losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2004 and 2003, the reserve for potential non-recoveries from reinsurers was $279 million and $108 million, respectively.
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% (2003: 5%). The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The Company decreased the interest rate from 7% to 5% in 2003 in line with current investment yields on this portfolio. The effect of the decrease in the interest rate resulted in an increase in loss reserves of approximately $35.0 million in 2003. The amount of the discount credit included in net losses and loss expenses incurred was $22.6 million in 2002. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2004 and 2003 were $578.6 million and $538.8 million, respectively. The related discounted unpaid losses and loss expenses were $290.0 million and $263.8 million as of December 31, 2004 and 2003, respectively.
The Company’s exposure to asbestos and environmental claims arises from policies written, both on a proportional and excess basis, after 1972. The Company discontinued writing policies with these exposures in 1985. Business written was across many different policies, each with a relatively small contract limit. The Company’s recently reported asbestos claims related to both traditional products and premises and operations coverage.
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, 2004, 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.
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. In 2001, the Company performed a detailed analysis of contracts it believed were exposed to this event. A net loss of $795.9 million related to the September 11 event was recorded in the year ended December 31, 2001. Included in the this net loss were net losses and loss expenses of $760 million. During 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 2003, the Company reduced loss reserves by $197.2 million related to the reinsurance segment, primarily aviation lines, due to higher than expected levels of participation (97%) in the September 11 Victims Compensation Fund. During 2004, the Company increased reserves by $18.7 million primarily as a result of an increase in accident and health claims related to the September 11 event.
The effect of reinsurance and retrocessional activity on premiums written and earned from general operations is shown below:
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $3.0 billion, $1.9 billion and $1.4 billion for the years ended December 31, 2004, 2003 and 2002, respectively. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $1.6 billion at December 31, 2003, collateralizing reinsurance recoverables with respect to certain reinsurers.
The Company has entered into certain contracts with cedants 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.
Interest expense of $129.9 million, $105.1 million and $65.9 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2004, 2003 and 2002, respectively.
“Commitment” and “In Use” data represent December 31, 2004 accreted values.
“Commitment” and “In Use” data represent December 31, 2003 accreted values.
There were no borrowings or repayments under the Company’s revolving credit facilities during 2004 or 2003.
In June 2004, the Company replaced its principal revolving credit and letter of credit facility that had amounted to $2.5 billion with two facilities - one $2.0 billion facility with a tenor of 3 years and a $1.0 billion facility with a tenor of 364 days. Of the aggregate amount of $3.0 billion, $600 million is available as revolving credit and up to $3.0 billion is available in the form of letters of credit, with the combined total not to exceed $3.0 billion. As at December
In November 2004, the Company renewed its unsecured syndicated letter of credit facility that supports its operations at Lloyd’s. The renewed facility is denominated in U.K. sterling and was £450 million (approximately $863 million) at December 31, 2004.
In November 2004, the Company issued the second tranche of $300 million aggregate principal amount of 5.25% Senior Notes due September 2014. The bonds were issued at 98.419% and gross proceeds were $298.7 million. Related expenses of the offering amounted to approximately $2.0 million. Proceeds of these notes, together with proceeds from the issuance of the 2024 senior notes described below, were used to redeen the Zero Coupon Convertible Debentures (“CARZ”) as described below.
In March 2004, the Company issued 33 million 6.5% Equity Security Units (“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 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 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 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
In May 2001, the Company issued $1,010.8 million principal amount at maturity of CARZ. On May 26, 2004, the Company made a one-time cash payment to holders of the CARZ for not exercising their put rights. On November 8, 2004, the Company redeemed the entire issue of CARZ at a total cost of approximately $657.6 million using proceeds from the issuance of the second tranche of Senior Notes due 2104 and the Senior Notes due 2024, as described above.
The following table summarizes these instruments and the effect on net income in the years ended December 31, 2004, 2003 and 2002:
The change in fair value recorded for the weather and energy derivatives was a gain of $2.0 million, $1.1 million and $16.6 million for the year ended December 31, 2004, 2003 and 2002, respectively.
The Company also uses foreign exchange forward contracts, in certain cases to hedge net investments in foreign operations against adverse movements in exchange rates. The Company manages its consolidated net foreign exchange exposure and from time to time hedges specific net in foreign operations. The Company measures ineffectiveness based upon the change in forward rates. For the year ended December 31, 2004, $26.7 million of net losses related to these foreign exchange forward contracts and were included in the cumulative translation adjustment. For the same period, no net losses were recorded in earnings representing the amount of the hedges’ ineffectiveness as the change in the value of the forward contract was fully offset by a corresponding change in the underlying investment.
daily basis and changes in fair values are recorded through net realized and unrealized gains and losses on derivative instruments. The Company measures potential losses in fair values using various statistical techniques.
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.
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.
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 $505.8 million and $467.0 million at December 31, 2004 and 2003, 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 Company manages its exposures to underwriting risk on these transactions through a structured process which includes but is not limited to detailed credit analysis, review of and adherence to underwriting guidelines and the use of reinsurance. The Company has also implemented surveillance policies and procedures to monitor its exposure throughout the life of the transactions. In addition, the structures of the transactions are such that the insured obligation is backed by a stream of cash flows, pools of assets or some other form of collateral. This collateral would typically become the Company’s upon the payment of a claim by the Company.
The following table presents financial guaranty aggregate insured portfolios at December 31, 2004 where the net par outstanding was $76.0 billion, which includes credit default swap exposures of $11.3 billion. The net principal and interest insured as of December 31, 2004 and 2003 was $108.3 billion and $77.3 billion, respectively. The liability for these credit derivatives had a carrying value of $49.5 million and $131.6 million at December 31, 2004 and 2003, respectively.
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 2004, 2003 and 2002, approximately 22%, 24% and 23%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by Marsh & McLennan Companies. During 2004, 2003 and 2002, approximately 17%, 17% and 17%, 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 any of the three years ended December 31, 2004, 2003, or 2002.
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, 2004, 2003, or 2002.
incurred losses and premium balances relating to the acquired Winterthur International business (“Winterthur Business”). This protection is 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 includes an independent actuarial process for determining the net amount due to the Company from the Seller. In this process, each of the Company and the Seller submits their respective net reserves and seasoned premium amounts. The independent actuary develops its own value of the seasoned net reserves and seasoned premium amounts and the actual final seasoned amount would be in each case, the submission that is closest to the number developed by the independent actuary.
As the Company and the Seller were unable to come to an agreement, the Company submitted to the Seller notice to trigger the independent actuarial process as contemplated by the SPA. On February 3, 2005, both the Company and the Seller have made submissions for the independent actuarial process. The Company’s submissions would result in a net payable to the Company of approximately $1.45 billion in aggregate and the Seller’s submissions would result in a net payable to the Company of $541 million in aggregate. At the completion of the independent actuarial process, the Company will be entitled to a lump sum payment.
A submission of the Seller is closer to the valuation developed by the independent actuary
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. The Company has commitments which include potential additional add-on clauses, to invest a further $2.2 million over the next five years.
The Company rents space for certain of its offices under leases that expire up to 2017. Total rent expense under operating leases for the years ended December 31, 2004, 2003 and 2002 was approximately $31.2 million, $42.3 million and $30.4 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
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 $185.2 million and $150.0 million as, and deferred a gain of $54.5 million and $50.0 million related to the sale at December 31, 2003 related to this lease at December 31, 2004 and 2003, 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 $369.5 million and annually for the next five years are as follows:
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 2004, 2003 and 2002 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.
Restricted stock awards issued under the 1991 Performance Incentive Program vest as set forth in the applicable award agreements. These shares contained certain restrictions, prior to vesting, relating to, among other things, forfeiture in the event of termination of employment and transferability. As the shares are issued, deferred compensation equivalent to the fair market value on the date of the grant is charged to shareholders’ equity and subsequently amortized over the vesting period. Restricted stock issued under the plan totaled 596,411 shares, 496,671 shares, and 225,960 shares in 2004, 2003, and 2002, respectively.
The following table summarizes information about the Company’s stock options (including stock appreciation rights) for options outstanding as of December 31, 2004:
Includes 1,601 options outstanding and exercisable, with an average exercise price of $30.59 that have no expiration date. These options are not included in the calculation of the average remaining contractual life.
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 $38.8 million, $27.5 million and $22.2 million in the years ended December 31, 2004, 2003 and 2002, respectively.
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 $27.0 million, $27.0 million and $13.8 million, respectively, as of December 31, 2004, and $23.9 million, $23.9 million and $13.1 million, respectively, as of December 31, 2003.
In 2003, four regular quarterly dividends were paid at $0.48 per share to ordinary shareholders of record as of March 10, June 9, September 8 and December 8.
The income tax provisions for the years ended December 31, 2004, 2003 and 2002 are as follows:
The valuation allowance at December 31, 2004 and December 31, 2003 of $68.5 million and $18.3 million, respectively, relates to net operating loss carryforwards in Switzerland and Australia that may not be realized within a reasonable period. The deferred tax asset for certain net operating loss carryforwards and valuation allowance at December 31, 2003, was reduced by $22.4 million for amounts attributable to the pre-acquisition period of certain affiliates. U.S. net operating loss carryforwards at December 31, 2004 were approximately $248 million and will expire in future years through 2023. As of December 31, 2004, net operating loss carryforwards in the U.K. were approximately $270 million and have no expiration. As of December 31, 2004, net operating loss carryforwards in Switzerland were approximately $311 million and will expire in future years through 2011.
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) 2000 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 2000 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, 2004 and 2003 was as follows:
The difference between statutory financial statements and statements prepared in accordance with GAAP vary by jurisdiction however the primary difference is that statutory financial statements do not reflect deferred policy acquisition costs, deferred income tax net assets, intangible assets, unrealized appreciation on investments and any unauthorized/authorized reinsurance charges.
On December 31, 2002, the Company entered into an agreement with Annuity and Life Reinsurance, Ltd. (“ALRE”), a subsidiary of Annuity and Life Re (Holdings), Ltd. (“ANR”), pursuant to which the Company assumed certain blocks of life reinsurance business. The Company has an investment in ANR that is accounted for as an affiliate under the equity method pursuant to APB Opinion 18, but the Company does not have the ability to control ANR or direct its operating and financial policies. Under the agreement, the Company assumed five blocks of life reinsurance business from ALRE and entered into a 50% quota share reinsurance contract with ALRE with respect to four of those blocks of business. As consideration for the novation of the five blocks of business from ALRE, the Company made a payment of approximately $44.0 million. As consideration for the 50% quota share reinsurance contract, the Company received a ceding commission of approximately $26.0 million. In connection with the transferred blocks of business, ALRE also transferred to the Company approximately $66.0 million in assets and related future policy benefit reserves. The 50% quota share reinsurance contract is structured as a modified coinsurance arrangement, as such, the Company recorded a liability for the funds withheld in reinsurance balances payable on the balance sheet in the amount of $25.0 million.
On August 5, 2003, the Company, under the terms of its 50% quota share reinsurance contract (the “quota share contract”) with Annuity and Life Reinsurance, Ltd. (“ALRE”), notified ALRE of its intention to elect to automatically terminate the quota share contract and recapture the business previously ceded to ALRE. Following this notice and with effect from June 30, 2003, the Company entered into a comprehensive settlement with ALRE, which in addition to the quota share contract, commuted or otherwise terminated all reinsurance relationships that the Company had with ALRE. As settlement of the quota share contract and the other insurance and reinsurance relationships, the Company received proceeds of $6.0 million.
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 $3.6 billion as of December 31, 2004.
The following is a summary of the unaudited quarterly financial data for 2004 and 2003:
In the third quarter of 2003, the Company recorded net losses and loss expenses incurred of $184.0 million pre-tax (approximately $160.0 million after tax) for higher than expected reported losses in its North American casualty reinsurance operations for the 1997 to 2000 underwriting years. In conjunction with this increase, the Company announced it had begun an extensive claims audit review of the relevant cedents for this book of business to have more complete information to determine ultimate loss reserves.
Also in the fourth quarter of 2003, the Company assumed two portfolios of long duration, closed block annuity reserves of approximately $390.0 million.