Total rent expense for the years ended December 31, 2005, 2004 and 2003 was approximately $34.9 million, $31.2 million and $42.3 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 the twelve months ended December 31 in prior years and the twelve months ended November 30 in subsequent years. The fair market values of certain of these alternative investments often take longer to obtain as compared to the other of our investments and we record the investment affiliates on a one month lag in order for us to meet the accelerated filing deadlines as specified by the SEC.
The underwriting expense ratio is the sum of acquisition expenses and operating expenses for general insurance and reinsurance operations divided by net premiums earned for general insurance and reinsurance operations. See Item 8, Note 3 to the Consolidated Financial Statements for further information.
The combined ratio is the sum of the loss and loss expense ratio and the underwriting expense ratio. A combined ratio under 100% represents an underwriting profit and over 100% represents an underwriting loss.
The Company operates on a global basis primarily in the property and casualty industry and, to a lesser extent, the financial services industry. The Company serves the insurance, reinsurance and financial services needs of institutional and corporate clients, typically the global equivalent of the Fortune 2000. The Company operates in markets where the Company believes its underwriting expertise and financial strength represent a relative advantage. The Company does not operate in any retail markets.
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 Inc. and XL Life Insurance & Annuity Company. 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.
The Company expects net investment income to rise in 2006 supported by positive cash flow from operating activities and anticipated moderate increases in market interest rates.
In 2005, the Company generated net realized gains from both its equity and fixed income portfolios, reflecting the current and accumulated performance of the capital markets. In 2004, the Company generated net realized gains from both its equity and fixed income portfolios reflecting the overall performance of capital markets and the deterioration of the U.S. dollar relative to foreign currencies. In 2003, the Company generated net realized gains from both its equity and fixed income portfolios reflecting the overall improvement in capital markets and narrowing of credit spreads.
Management also views the change in the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by
the Company’s net income and also by any changes in the net unrealized gains and losses on its investment portfolio. The Company’s book value per ordinary share decreased in 2005 as a result of the underwriting losses incurred, partially offset by the significant capital-raising during December 2005, where ordinary shares were issued at a premium to the book value at that time. During 2005, book value per share also decreased as a result of a decrease in the unrealized gains on the Company’s investment portfolio. The decrease was primarily as a result of increasing short to medium term U.S. interest rates, partially offset by declining longer term U.K. interest rates. The Company’s book value per ordinary share increased in 2004, primarily as a result of an increase in net income combined with an increase in the net unrealized gains on the investment portfolio. The increase in unrealized gains on the Company’s fixed income portfolio was primarily a result of the foreign exchange benefits for non-U.S. dollar investments partially offset by a moderate increase in interest rates in the U.S.
Return on average ordinary shareholder’s equity (“ROE”) is a widely used measure of any company’s profitability. It is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes minimum target ROEs for its total operations, segments and lines of business. If the Company’s minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit these lines. In addition, the Company’s compensation of its senior officers is significantly dependent on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE. The Company reported a loss in 2005 and ROEs for the prior two years have been negatively affected mainly by its general operations’ underwriting results and investment income.
The Company’s ability to underwrite business is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company’s financial strength rating is downgraded, its ability to write business will be adversely affected. Such a downgrade would also adversely affect the Company’s financial guaranty lines of business. During the third and fourth quarters of 2005 a number of ratings actions were taken by independent rating agencies including some downgrades of the Company’s principal insurance and reinsurance subsidiaries. The Company subsequently raised $3.2 billion through an issuance of a combination of ordinary shares and equity security units. The financial strength ratings of the Company’s financial guaranty companies remain “triple A” with a stable outlook (by Standard & Poor’s, Moody’s and Fitch Ratings). For a further discussion see “Ratings” above.
Management has entered into a strategic initiative intended to augment the Company’s overall underwriting capacity to take advantage of opportunities in certain catastrophe-exposed lines of business. Management has entered into a collateralized quota share reinsurance treaty with Cyrus Reinsurance Limited. Under this agreement, as of January 1, 2006, the Company cedes specified portions of the Company’s property catastrophe reinsurance and retrocession lines of business.
ening catastrophe event scenarios, reduce catastrophe sublimits and eliminate accounts that no longer meet the Company’s increased pricing needs. In addition to the strategic initiative noted above, the Reinsurance segment’s management intends to reduce catastrophe exposure within the property risk portfolio and restructure the way in which marine excess of loss programs are written.
The Company’s ability to compete is influenced by its operational efficiency and effectiveness, including the development and retention of its people. In recognition of this, the Company has in place and continues to develop, programs and initiatives aimed at enhancing its position in these areas. For example, the Company continues to make significant investments in information technology in both the Insurance and Reinsurance segments, develop and implement a new framework for Financial Reporting and Controls, and establish an operations center, based in, India. Each of these projects requires considerable investment and commitment of the Company’s resources in an effort to achieve the ultimate goals of increased operational efficiency and effectiveness.
Another important matter on which management is focused (and which also affects the Company’s ability to underwrite business) is the availability of collateral. Collateral includes letters of credit, insurance trusts and other credit facilities required to provide security to cedants (which are companies who reinsure their liabilities to the Company), particularly as required by state insurance regulation in the U.S. and at Lloyd’s, and also to provide the Company with liquidity as required. These facilities are provided to the Company from commercial banks. Our principal credit facilities have tenors of two, three, and five years. The Company has also utilized “off balance sheet” transactions in order to obtain more collateral capacity (these transactions are described below under “Variable Interest Entities and Other Off Balance Sheet Arrangements”). As the Company writes more business, its collateral requirements will increase. A key challenge for management is to ensure that sufficient collateral capacity is available as to not hinder future writing of business.
As a property and casualty insurer, the Company must ensure that it has sufficient funds to settle claims promptly, especially upon the occurrence of a major catastrophic event. Management is focused on making sure that liquidity requirements are supported by having lines of credit facilities available to the Company as well as by the Company’s general investment portfolio of which the majority is in high grade fixed income securities. The Company has had significant positive cash flow from operations in the three years ended December 31, 2005 generated from its underwriting activities (premiums less claim and expense settlements) as well as the receipt of investment income on its portfolio. In addition during 2005, capital raising activity provided significant cash flows from financing activities. The Company expects cash flow from operations to be positive in 2006.
The Company’s net (loss) income and other financial measures as shown above for the three years ended December 31 have been affected, among other things, by the following significant items:
Net adverse prior year loss development in general insurance and reinsurance operations;
The following are analyses of the financial impact on the Company’s results of operations for the years ended December 31, 2005 and 2004 from natural catastrophes:
On December 6, 2005, the Company received the report from the Independent Actuary in connection with the Company’s post-closing protection for adverse development of net loss and unearned premium relating to the acquisition of certain Winterthur International insurance operations from Winterthur Swiss Insurance Company (“WSIC”) in 2001.
The Independent Actuary’s report concluded that WSIC’s submitted Seasoned Net Reserve Amount (“SNRA”) and Net Premium Receivable Amount (“NPRA”) were closest to the Independent Actuary’s determinations of SNRA and NPRA. These determinations resulted in the Company receiving a net lump sum payment in the amount of approximately $575.0 million (including interest receivable) from WSIC. As the Company had recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, a loss of approximately $808.9 million, net of interest, was recorded in the fourth quarter of 2005.
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 2005 related to the Company’s general insurance operations most notably in the casualty and professional lines of business.
The results for the year ended December 31, 2005 have been negatively impacted by adverse development in both the Insurance and Reinsurance segments. The following table presents the net adverse (favorable) prior year loss development of the Company’s loss and loss expense reserves for its general and financial operations by each operating segment for each of the years indicated:
The majority of the workers’ compensation reserve increase during 2005 was related to an XL Reinsurance America Inc. (“XLRA”) working layer program written across multiple underwriting years with a single cedent. This program was not renewed at the end of 2001. Other than this program, XLRA has not written significant working layer workers’ compensation business. The remaining source of the workers’ compensation reserve strengthening relates to an update of the mortality tables used in our tabular reserving methodology.
During 2004, the Company’s net adverse prior year development of $268.0 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.
See Item 8, Note 9 to the Consolidated Financial Statements and see further discussion under “Critical Accounting Policies and Estimates” and under “-Segments-Reinsurance” below.
4. Growing asset base and positive performance from investments in affiliates.
Net investment income was $1.5 billion in 2005 as compared to $1.0 billion in 2004 due primarily to a larger investment base combined with higher investment yields, as well as receipt of a distribution associated with the unwinding of a collateralized debt obligation which resulted in a one time benefit to investment income, and the accrued interest on the proceeds from the conclusion of the independent actuarial process with WSIC. The investment portfolio increased due to growth in structured and spread balances and positive operating cash flows combined with capital raising activities late in the fourth quarter. Higher investment yields were driven primarily by the impact of increasing U.S. interest rates on cash flow and reinvested assets. In addition, net realized gains produced by the investment portfolio and the equity earnings from the Company’s affiliates also contributed positively to the year. Net realized gains on investments were $241.9 million in 2005 compared to $246.5 million in 2004. Net income from investment affiliates was $154.8 million in 2005 compared to $124.0 million in 2004. This increase was attributable to good underlying alternative fund returns combined with strong results from certain private equity affiliates that benefited from a series of successful liquidation events. Net income from operating affiliates (including insurance, financial and investment manager affiliates) was $67.4 million in 2005 compared to $147.4 million in 2004. Earnings from investment manager affiliates were strong during 2005. Earnings from operating affiliates during 2004 included $102.1 million of income in connection with the sales of Admiral Group Ltd and Pareto Partners L.P. and its affiliated companies. See Item 8, Note 7 to the Consolidated Financial Statements.
The following are considered to be the Company’s critical accounting policies and estimates due to the judgments and uncertainties affecting the application of these policies and/or the likelihood that materially different amounts would be reported under different conditions or using different assumptions. If actual events differ significantly from the underlying assumptions or estimates applied for any or all of the accounting policies (either individually or in the aggregate), there could be a material adverse effect on the Company’s results of operations, financial condition and liquidity. These critical accounting policies have been discussed by management with the Audit Committee of the Company’s Board of Directors.
Case reserves - reserves for reported losses and loss expenses that have not yet been settled and,
With respect to the Company’s insurance operations, the Company is notified of insured losses and records a case reserve for the estimated amount of the settlement, if any. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of legal counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. With respect to the Company’s reinsurance general operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the estimated ultimate cost of a loss. With respect to the Company’s financial products and services operations, financial guaranty claims incurred on policies written on an insurance basis are established consistent with the Company’s insurance operations and financial guaranty claims incurred on policies written on a reinsurance basis are established consistent with the Company’s reinsurance operations.
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 that 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 Company’s net unpaid loss and loss expense general and financial reserves broken down by operating segment at December 31, 2005 and 2004 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, 2005:
(1) Other consists of several products, including accident and health, political risk, surety and bonding.
The Company writes both “short-tail” and “long-tail” lines of business. “Short-tail” and “long-tail” describe the time between the receipt of the premium from a policy and the final settlement of any loss incurred under such policy. Short-tail lines include property catastrophe, other property and certain marine and aviation lines where, on average, the settlement period may be up to 24 months. Long-tail lines, on the other hand, include the Company’s casualty business in which claims may take up to 30 years to be reported and settled. The increase in the time associated with ultimate settlement of a claim is directly related to an increase in the amount of judgment required to establish loss reserves, especially IBNR reserves.
See further discussion under “- Segments” below for prior year development of loss reserves.
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.
Discontinued asbestos and long-tail environment business had been previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to its acquisition by the Company.
As a result of the Company’s acquisition of Winterthur International in July 2001, WSIC provides protection to the Company with respect to third party reinsurance receivables and recoverables related to the Winterthur International acquisition, which are $1.6 billion in the aggregate, as of December 31, 2005. The Company has reinsurance protection under two retrocession agreements 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.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $5.2 billion and $3.9 billion at December 31, 2005 and 2004, respectively. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile. A 0.1% decrease in the investment yield assumption would result in a $49 million increase in the value of future claims related to annuity portfolio reinsurance.
The Company also provides reinsurance of disability income protection. The future policy benefit reserves for these contracts amounted to $85 million and $86 million at December 31, 2005 and 2004, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of 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 1% decrease in the termination rate would increase the value of future claims by approximately $0.4 million.
Following a review of morbidity experience, the locked-in assumptions were revised during the year ended December 31, 2005. The overall effect of using the revised assumptions was a reduction in income of $0.4 million.
The Company also provides reinsurance of term assurance and critical illness policies written in the U.K. and Ireland. The future policy benefit reserves for these contracts amounted to $62 million and $41 million at December 31, 2005 and 2004, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience.
The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide mainly lump sum benefits if the policyholder dies or becomes sick. For term assurance, the liabilities are therefore driven by the rates of mortality and for critical illness cover, the liabilities are driven predominantly by the rates at which policyholders become sick (where sickness is defined by the treaty conditions), i.e., the morbidity rates. A 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $0.6 million, and a 1% increase in the morbidity rate would increase the value of future claims by approximately $0.6 million.
The Company also provided reinsurance of U.S. based term assurance, which was novated to the Company from an insurance affiliate in December 2002. The future policy benefit reserves for these contracts amounted to $184 million and $123 million at December 31, 2005 and 2004, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience.
and a 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $8 million. Following a review of mortality experience, the locked-in assumptions were revised during the year ended December 31, 2005. The overall affect of using the revised assumptions was a reduction in income of $63 million. See Item 8, Note 12 to the Consolidated Financial Statements.
The Company’s deposit liabilities at December 31, 2005 reflect obligations assumed under funding agreements, municipal guaranteed reinvestment contracts, payment undertaking agreements and certain structured insurance and reinsurance agreements. For each of these contracts, the Company establishes a deposit liability equal to the net cash received at inception. Each deposit liability accrues at a rate equal to the internal rate of return of the payment receipts and obligations due during the life of the agreement. Where the timing and/or amount of future payments are uncertain, cash flows reflecting the Company’s actuarially determined best estimates are utilized. The ultimate size of underlying losses, the impact of the contractual limits upon settlement of such losses, and the impact of the underlying loss settlement process on the timing of payments are considered as appropriate. Where uncertainty is present, an increase in the ultimate claims cost or accelerated claims settlement would potentially lead to an increase in the deposit liability accretion rate or lead to incurred losses if significant. The interest expense reported due to the accretion of deposit liabilities associated with structured insurance and reinsurance contracts was $49.8 million, $59.4 million and $92.9 million for the years ended December 31, 2005, 2004 and 2003, respectively. For some of the Company’s deposit liabilities, the accretion rate is recorded at its contractual maximum level. For all other contracts, a 1% increase in the average accretion rate would result in an increase in deposit liabilities and interest expense by $16.3 million on an annualized basis. See Item 8, Note 11 to the Consolidated Financial Statements.
The Company conducts activities in three main types of derivative instruments: credit derivatives, weather and energy derivatives and investment-related derivative instruments. The estimate of fair value for credit derivatives and weather and energy derivatives requires management’s judgment. These two activities are discussed below:
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 and Item 8, Note 14 to the Consolidated Financial Statements.
have quoted market prices requires management’s judgment in determining amounts that could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis and Item 8, Note 14 to the Consolidated Financial Statements.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security’s unrealized loss represents an other than temporary decline. However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its ability to hold such securities is supported by positive and sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment obligations arising from its underwriting operations without selling such investments. In this regard, cash flow from operating activities was $4.2 billion and $4.4 billion in 2005 and 2004, respectively.
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 limited loss development at XLRA relating to these underwriting years through December 31, 2005. 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 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 cedent.
The Company operates through three business segments: Insurance, Reinsurance and Financial Products and Services. These business segments were determined in accordance with FAS No. 131, “Disclosures about Segments of an Enterprise and Related Information”.
The Company’s segment results have been significantly impacted by the catastrophe loss events of 2005 and 2004, as noted above. These should be considered when making period to period comparisons of segment results.
Net premiums earned increased in each of the two years ended December 31, 2004 and 2003 due to the increases in net premiums written in each year, as noted above. Growth in net premiums earned in 2004 and 2003 were partially offset by several non-renewed portfolios as the earned premium impact of the non-renewed business lags behind the written premium impact.
The loss and loss expense ratio for the Insurance segment for the year ended December 31, 2005 increased compared with the year ended December 31, 2004, primarily reflecting the net losses of $947.0 million incurred in the property catastrophe and property lines of business as a result of Hurricanes Katrina, Rita and Wilma and the Other Cats combined with the impact of overall continued softening market conditions in 2005, losses of $834.2 million representing the unfavorable outcome of the independent actuarial process with WSIC and $185.8 million in net adverse prior year development.
expenses related to the South Asia Tsunami. 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 following tables present the prior year adverse or favorable development of the Company’s gross and net loss and loss expense reserves for its insurance operations:
Included in net adverse prior year development is the loss associated with the independent actuarial process with WSIC. The Independent Actuary’s report concluded that WSIC’s submitted SNRA and NPRA were closest to the Independent Actuary’s determinations of SNRA and NPRA. These determinations resulted in the Company receiving a net lump sum payment in the amount of approximately $575.0 million (including interest receivable) from WSIC. As the Company had recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, incurred losses of approximately $834.2 million were recorded in the fourth quarter of 2005.
During 2005, the Insurance segment’s net adverse prior year development, excluding the impact of the result of the independent actuarial process, of $185.8 million was driven primarily by increases in reported case reserves for excess professional liability. Strengthening of $259.5 million in professional lines was caused primarily by the establishment of case reserves on both directors’ and officers’ claims in pre-2002 business, and errors and omissions claims. Strengthening of $34.7 million within other specialty lines was caused primarily by increases in reported losses for specialty lines of business currently in run-off including certain Lloyd’s business, discontinued programs business, and surety. A net release of $112.5 million for global risk lines of business was driven by the reduction in case reserves for pre-2002 claims primarily relating to casualty business written out of Europe.
During 2004, the segment’s net adverse development of $292.0 million was driven primarily by increases in reported case reserves for excess professional liability, excess casualty liability and specialty lines. These increases in reported case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Strengthening of $144.0 million in professional lines was caused by a few large directors’ and officers’ claims in pre-2002 business, while increases in errors and omissions reserves were caused by loss related to large accounting firms and insurance and reinsurance brokers. For specialty lines, strengthening of $135.0 million was caused by reported loss increases in discontinued programs business with workers’ compensation exposure, environmental related coverages, certain Lloyd’s business and high severity claims on the surety book.
During 2004 and 2003, the Company’s net adverse development of its gross reserves greatly exceeded its net reserve adverse development due principally to an increase in prior year reserves related to Winterthur International. The Company had protection with respect to any adverse loss or premium development related to the acquired Winterthur International insurance operations with effect from July 1, 2001, under the SPA with WSIC, and recorded a recoverable of the same amount.
The underwriting expense ratio for the year ended December 31, 2005 decreased compared with the same period in 2004 as a result of a decrease in the operating expense ratio of 0.5 points (12.6% as compared to 13.1%) combined with a decrease in the acquisition expense ratio of 0.8 points (12.4% as compared to 13.2%) . The reduction in the operating expense ratio was due to productivity expense management initiatives and certain compensation cost adjustments. The reduction in the acquisition expense ratio was due primarily to a change in the commission structure with certain brokers, partially offset by the impact of ceded reinstatement premiums.
The underwriting expense ratio for the year ended December 31, 2004 compared to the same period in 2003 increased slightly. The decrease in the acquisition expense ratio of 1.6 points (13.3% as compared to 14.9%) was offset by an increase in the operating expense ratio of 1.8 points (13.1% as compared to 11.3%) . The reduction in the acquisition expense ratio was due primarily to a change in the mix of business earned compared to the same period in the prior year and changes in the commission structure with certain brokers. The increase in the operating expense ratio was due primarily to the increased costs associated with supporting new business growth in the segment operations globally, including start up operations, an allocation of certain corporate expenses to the Insurance segment and the impact of foreign exchange movements.
The following table summarizes the underwriting results for the general operations of the Reinsurance segment:
The increase in the loss and loss expense ratio in the year ended December 31, 2005, compared to the same period in 2004, primarily reflected the effects of Hurricanes Katrina, Rita and Wilma combined with the Other Cats from which the Reinsurance segment incurred a combined $977.9 million of net losses. These natural catastrophes added 34.4% to the segment loss ratio for the year ended December 31, 2005. In addition, there was higher than expected adverse prior year development of $93.5 million relating to primarily U.S. casualty business partially offset by reserve releases in short tail lines, as discussed further below.
During 2005, the Insurance segment’s net adverse prior year development of $1.02 billion includes the results of the independent actuarial process noted above. Excluding this development the remaining $185.8 million was driven primarily by increases in reported case reserves for excess professional liability. Strengthening of $259.5 million in professional lines was caused primarily by the establishment of case reserves on both directors’ and officers’ claims in pre-2002 business, and errors and omissions claims. Strengthening of $34.7 million within other specialty lines was caused primarily by increases in reported losses for specialty lines of business currently in run-off including certain Lloyd’s business, discontinued programs business, and surety. A net release of $108.4 million for global risks lines of business was driven by the reduction in case reserves for pre-2002 claims primarily relating to casualty business written out of Europe.
In the fourth quarter of 2003, the Company reduced aviation loss reserves related to the September 11 event by $197 million. This reduction in reserves was due to higher than expected levels of participation (97%) in the September 11 Victim Compensation Fund, a no-fault compensation scheme funded by the U.S. Government, which closed on December 22, 2003. This resulted in a reduction of the estimated ultimate losses by the Company for this event.
Incurred but not reported losses, net of reinsurance, included in the above table was $16.7 million at December 31, 2005, $22.5 million at December 31, 2004 and $27.0 million at December 31, 2003. Unpaid losses recoverable are net of potential uncollectible amounts.
Life and annuity gross and net premiums written, net premiums earned and claims and policy benefits in each of the three years ended December 31, 2005, 2004 and 2003 included the assumption of the following long duration annuity portfolios:
1. Second and fourth quarters of 2005 - A large U.K. immediate annuity portfolio contract bound representing $1.8 billion in net premiums earned and two smaller Irish immediate annuity portfolios amounted to $96.2 million.
2. Second and fourth quarters of 2004 - Two large U.K. portfolio contracts, representing $995 million in net premiums earned and related claims and policy benefits.
3. Fourth quarter of 2003 - two portfolios, one U.K. and one Irish, 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 2005 compared with 2004 and 2004 compared with 2003, as the Company expanded its life and annuity reinsurance operations in Europe, and continues to bind additional regular premium term assurance contracts which generate ongoing premiums.
Claims and policy benefits also increased significantly in 2005 as compared to 2004, as a result of the annuity payout liabilities accepted under the contracts noted above where investment assets were acquired with the assumption of the policy benefit reserves at the inception of the contract. In addition, $37.4 million in losses were recorded during the second quarter of 2005 related to certain novated blocks of U.S.-based term life mortality reinsurance business as a result of the actuarially modeled impact of actual paid losses being greater than expected. In accordance with U.S. GAAP treatment for life business, a loss recognition test process was carried out to determine if expected future premiums would be sufficient to pay for expected future losses. This process led to management’s decision to unlock the current policy benefit reserve ratio and record a loss.
Acquisition costs increased in the year ended December 31, 2005 as compared to the year ended December 31, 2004 reflecting the write-off of certain deferred costs of $25.9 million, including value of business assumed related to the U.S. mortality business noted above, as current profit projections did not support the recovery of the deferred costs booked in the prior year. Operating expenses increased in 2005 compared to 2004 due to build-out of existing operations and start-up costs of new life operations in the U.S.
Decreases in gross and net premiums written of 4.2% and 7.2%, respectively, in 2004, as compared to 2003, were primarily due to lower financial guaranty premiums written, resulting from management’s underwriting and pricing discipline during generally weaker market conditions in 2004. In addition, during 2004 there were fewer large up-front premium contracts written, as compared with the prior year. Financial guaranty market conditions in 2004, as compared to 2003 were characterized by tighter credit spread compression, higher interest rates, increased competition and reduced public financing volume.
(1) Includes structured property and casualty and alternative risk transfer products and weather and energy risk management products.
The increase in net premiums earned of 11.0% during 2005, as compared to 2004, primarily resulted from additional premiums due in 2005 on a structured property and casualty policy which incurred a loss related to Hurricane Katrina, as well as new structured property and casualty business production in 2005, offset in part by lower earned premium in our financial guaranty line of business in 2005, as compared to 2004. The year over year decrease in earnings in our financial guaranty line of business was primarily attributable to $23.3 million of premium earnings recorded in 2004 relating to an insured project financing on which a full-limit loss was recognized during the year (for further discussion see “Net losses and loss expenses” below).
project financing structure, as well as a net increase in unallocated reserves resulting from the growth in financial guaranty in force business, offset by a decrease in reserves in 2004, as compared to 2003, relating to non-investment grade credit default swaps of approximately $37.4 million.
For 2005, acquisition costs decreased by approximately $0.4 million. This decrease consisted of higher acquisition expenses in our guaranteed investment contract and funding agreement businesses, offset by lower acquisition expenses in our financial guaranty business. Lower acquisition expenses in our financial guaranty business were primarily the result of ceding proportionally more installment business relative to upfront business in 2005, as compared to 2004. Risk on installment business generally expires faster than that on upfront business, which resulted in a higher year over year amortization of deferred commissions. For 2004 acquisition costs decreased compared with 2003 reflecting a change in the average life of the financial guaranty in force book of business over which such costs are expensed.
For 2005, net operating expenses, including non-structured and structured products, were $113.6 million, a decrease of $6.6 million from $120.2 million in 2004. The favorable movement was mostly attributable to a reduction in compensation expense and professional fees. For 2004, net operating expenses, including non-structured and structured products, increased by $32.2 million to $120.2 million from $88.0 million for 2003 due primarily to the investment in segment infrastructure and continued build-out of the financial products platform as well as an increase in the allocation of certain corporate expenses.
well as the change in accounting related to the Company’s investment in FSAI to conform with the requirements of EITF 02-14 as discussed above. Primus specializes in providing credit risk protection through credit derivatives. Net income from financial affiliates also decreased in 2004, as compared to 2003, due primarily to the Company’s investment in Primus. Primus had a mark-to-market adjustment in 2004, which was less favorable than that recorded in 2003. This decrease was partially offset by income from the sale of a portion of the Company’s investment in Primus, in connection with the initial public offering of Primus in the fourth quarter of 2004.
Net results from structured derivatives represent changes in the market value of the segment’s insured credit derivative portfolio, as well as results from its weather and energy derivative business and certain structured financial risk management products. Net results from structured derivatives decreased 8.2% in 2005, as compared to 2004. Results in 2005 primarily consist of (i) $8.2 million of unrealized gains resulting from the reclassification to “net losses and loss expenses” of an incurred loss on a credit default swap, (ii) an $18.6 million gain on the settlement of a structured market risk management derivative product tied to a housing price index, and (iii) $17.8 million net realized and unrealized gains in the weather and energy business. Results in 2004 primarily consist of (i) net unrealized gains on the credit derivative portfolio of $44.2 million resulting primarily from tightening credit spreads during the year, (ii) $3.3 million of net realized and unrealized gains on the structured financial derivative business, and (iii) $2.0 million of net realized and unrealized gains in the weather and energy business.
Net income from investment affiliates in 2004 and 2005 reflect the twelve months to November 30, 2004 and 2005, as compared to the eleven months ended November 30, 2003. The Company records the investment affiliates on a one month lag in order for the Company to meet the accelerated filing deadlines as specified by the SEC.
Net investment income related to general operations increased in 2005 as compared to 2004 primarily due to growth in the investment base, as well as increases in the yield of the portfolio. The growth in the investment base reflected the Company’s cash flow from operations. The Company also received a distribution associated with the unwinding of a collateral debt obligation, which resulted in a one-time benefit to investment income. In addition, the Company received investment income of $25.3 million on related to the conclusion of the independent actuarial process with WSIC.
The Company’s total investments available for sale and cash and cash equivalents less net pending payable for investments purchased was $38.8 billion at December 31, 2005 as compared to $29.8 billion at December 31, 2004. This increase of $9.0 billion includes (i) cash flow from financing activities of $3.2 billion in the fourth quarter of
It is expected that net investment income in 2006 will increase due to projected increases in investments resulting from the full year effect of investing proceeds from the December 2005 capital raise, and monies received from conclusion of the independent actuarial process with WSIC, 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. For a further discussion see “Liquidity and Capital Resources.”
Net income from investment affiliates includes earnings from the Company’s investments in closed-end investment funds and partnerships and similar vehicles that are equity accounted. Net income from investment affiliates increased in 2005 as compared to 2004 primarily due to a strong result in private equity portfolios due to a series of positive liquidity events, with continued good returns on the alternative portfolios.
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. 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 the years ended December 31, 2005 and 2004 of the general account asset/liability portfolio, structured and spread product portfolio and risk asset portfolios.
Net realized and unrealized gains on investment derivatives result from the Company’s investment strategy to economically hedge against interest and foreign exchange risk within the investment portfolio. For a further discussion see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” and “- Liquidity and Capital Resources.”
At December 31, 2005, there were $312.7 million of gross unrealized losses on fixed income and short-term investments, and $8.8 million of gross unrealized losses on equity securities. 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. These losses include securities below investment grade, as discussed below.
The following is an analysis of the length of time each of those investment securities at December 31, 2005 and 2004 had been in a continual unrealized loss position:
At December 31, 2005, the total gross unrealized losses represented approximately 9,100 fixed income securities out of a total of approximately 17,300 and approximately 400 equity securities out of a total of approximately 1,800. At December 31, 2004, the total gross unrealized losses represented approximately 5,100 fixed income securities out of a total of approximately 15,300, and approximately 200 equity securities out of a total of approximately 1,600.
of the Company’s fixed income investment portfolio was invested in securities that 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 following is an analysis of the length of time each of those below investment grade and unrated securities had been in a continual unrealized loss position at the date indicated.
Of the gross unrealized investment losses on the fixed income and short term investments portfolio at December 31, 2005 of $312.7 million, approximately $118.8 million related to corporate fixed income securities. Within the corporate fixed income securities, approximately 55.3% of the losses were in the financial sector, 9.8% in the communications sector, 9.4% in the consumer non-cyclical sector, and 5.6% in the consumer cyclical sector. No other sector was greater than 5%. The largest unrealized loss in the fixed income portfolio was $5.0 million. No equity securities held by the Company at December 31, 2005 were in a continual unrealized loss position for at least 12 months. The largest individual unrealized loss in the equity portfolio was $0.3 million.
At December 31, 2005 and 2004, the following table sets forth the maturity profile of the fixed income securities (excluding short term) that were in a gross unrealized loss position:
The following table sets forth other revenues and expenses of the general operations of the Company for each of the three years ended December 31:
In 2005, net income from operating affiliates declined over 2004, which resulted from the fact that the 2004 results included proceeds from the sale of two affiliates, as described below. The results of the Company’s investment management affiliates showed good underlying growth in 2005 due to good investment performance and growth in assets managed by these minority-owned managers.
In 2004, the increase in net income from operating affiliates included strong performance by the Company’s investment management affiliates combined with income of $66.7 million on the sale of the Company’s investment in the Admiral Group Ltd. and $35.4 million of income from the sale of the Company’s stake in Pareto Partners L.P. and its affiliated companies, as well as strong growth in assets managed by these minority-owned managers.
Corporate operating expenses in 2005 decreased by 10.0% primarily as a result of Company-wide cost reduction efforts combined with reduced compensation costs and partially offset by increased legal costs. Corporate operating expenses in 2004 increased 35.5% compared to 2003 due to the continued build-out of the Company’s global infrastructure and personnel in developing its network of shared service organizations to support operations in certain locations, costs related to compliance with the Sarbanes-Oxley Act, and adverse foreign exchange impacts.
Interest expense includes costs related to the Company’s debt and collateral facilities as well as deposit liability accretion. The increase in interest expense primarily reflected the increase in average outstanding debt for the year ended December 31, 2005, compared to 2004. For more information on the Company’s financial structure, see “Liquidity and Capital Resources”.
The change in the Company’s income taxes in each of the three years ended December 31, 2005, 2004 and 2003 principally reflects the effects of changes in the profitability of the U.S. and European operations for each year. Income tax expense for the year ended December 31, 2005 decreased from 2004, due primarily to losses incurred in the Company’s U.S. operations as a result of the 2005 catastrophe activity. A significant proportion of the loss reserve increases are captured in non-U.S. subsidiaries where no tax relief is available.
The deferral of tax losses is evaluated based upon the future profitability of the Company’s taxable entities and, under current projections, the Company anticipates using this asset. The Company’s net deferred tax asset at December 31, 2005 was $318.4 million, which consists primarily of net operating losses generated by subsidiaries in the U.S. and U.K. Should the taxable income of these entities fall below expectations, a further valuation allowance may have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax effected. See “Critical Accounting Policies and Estimates” and Item 8, Note 23 to the Consolidated Financial Statements.
The primary objective of the investment strategy is to support the liabilities arising from the operations of the Company, generate stable investment income and to build book value for the Company over the longer term. The strategy strives to maximize investment returns while taking into account market and credit risk. The Company’s overall investment portfolio is structured to take into account a number of variables including local regulatory requirements, business needs, collateral management and risk tolerance.
At December 31, 2005 and 2004, total investments and cash and cash equivalents were $41.2 billion and $32.1 billion, respectively. The following table summarizes the composition of the Company’s invested assets at December 31, 2005 and 2004:
The Company reviews on a regular basis its corporate debt concentration, credit quality and compliance with established guidelines. At December 31, 2005 and 2004, the average credit quality of the Company’s total fixed income portfolio was “AA.” At December 31, 2005 approximately 57.2% of the fixed income portfolio was rated AAA by one or more of the principal ratings agencies. Approximately 2.4% was below investment grade or not rated.
Unpaid losses and loss expenses include reserves on the Company’s general and financial operations and relates primarily to the casualty insurance and reinsurance business written by the Company. The balance was $23.8 billion at December 31, 2005, which is an increase of $4.0 billion from December 31, 2004. The increase was due primarily to $3.8 billion in gross losses from catastrophe activity in 2005.
While the Company reviews the adequacy of established reserves for unpaid losses and loss expenses regularly, no assurance can be given that actual claims made and payments related thereto will not be in excess of the amounts reserved. In the future, if such reserves develop adversely, such deficiency would have a negative impact on future results of operations. See Item 1, “Unpaid Losses and Loss Expenses”, “Critical Accounting Policies and Estimates” and Item 8, Note 9 to the Consolidated Financial Statements for further discussion.
Unpaid losses and loss expense recoverables were $6.4 billion and $7.0 billion at December 31, 2005, and 2004, respectively. At December 31, 2005 and 2004, reinsurance balances receivable were $1.0 and $1.1 billion, respectively. The table below presents the Company’s net reinsurance recoverable at December 31, 2005 and 2004.
The Company has credit risk should any of its reinsurers be unable or unwilling to settle amounts due. Of the $7.5 billion total unpaid losses and loss expenses recoverable and reinsurance balances receivable at December 31, 2005, no individual reinsurer accounted for 10% or more of the total. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $2.1 billion at December 31, 2005, collateralizing reinsurance recoverables with respect to certain reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify the Company primarily because of disputes under reinsurance contracts and insolvencies. As at December 31, 2005 and 2004, the Company had a reserve for potential non-recoveries from reinsurers of $260.7 million and $280.7 million, respectively.
Under the terms of the SPA, WSIC provides the Company with protection with respect to third party reinsurance receivables and recoverables related to the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”), which were approximately $1.6 billion, in the aggregate, as of December 31, 2005. There are two levels of protection for these balances:
At the time of the Winterthur International acquisition, WSIC provided to the Company a liquidity facility. At the time of the payment of the net reserve seasoned amount on December 12, 2005, the Company exercised its right to repay up to the balances outstanding on this facility by assignment to WSIC of an equal amount of receivables relating to reinsurance recoverables selected by the Company. During December 2005, the Company assigned $265.4 million of receivables to WSIC under this arrangement, although WSIC has disputed the assignment of certain of these receivables.
As a holding company, the Company’s assets consist primarily of its investments in subsidiaries, and the Company’s future cash flows depend upon the availability of dividends or other statutorily permissible payments from its subsidiaries. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries in which the Company operates, including, among others, Bermuda, the United States, Ireland, Switzerland, the United Kingdom, and those of the Society of Lloyd’s and certain contractual provisions. See Item 8, Note 24 to the Consolidated Financial Statements for further discussion. No assurance can be given that the Company or its subsidiaries will be permitted to pay dividends in the future.
Certain business written by the Company has loss experience generally characterized as having low frequency and high severity. This may result in volatility in both the Company’s results and operational cash flows.
The net receipt of premiums less claims and expenses related to its underwriting activities in general, life and annuity and financial operations.
Cash flow from operations was $4.2 billion in 2005, as compared to $4.4 billion in 2004. The decrease in 2005 is due primarily to cash payments on catastrophe losses during 2005, partially offset by the receipt of a net lump sum payment of $575.0 million from WSIC, related to the conclusion of the independent actuarial process and an increase in the receipt of investment income in line with increasing interest rates and the growth of the investment portfolio.
Net cash received from underwriting activities is comprised of receipt of premiums, minus payment of claims and operating and acquisition costs. Premiums and acquisition expenses are settled based on terms of trade as stipulated by an underwriting contract, and generally are received within the first year of inception of a policy when the premium is written, but can be up to three years on certain reinsurance business assumed. Operating expenses are generally paid within a year of being incurred. Claims especially for casualty business, may take a much longer time before they are reported and ultimately settled and this is why the Company establishes reserves for unpaid losses and
In December 2003, the Company received $75.4 million relating to the agreement reached with WSIC as to the final purchase price for Winterthur International. See Item 8, Note 5(b) to the Consolidated Financial Statements for further information.
In July 2003, the Company acquired new offices in London for its London headquarters. The acquisition was by a purchase, sale and leaseback transaction resulting in net cash received of $45.3 million, which was recorded as a deferred liability at December 31, 2003. The Company also recorded a capitalized lease asset and liability of approximately $150.0 million related to this transaction and there were no significant capital expenditures for leasehold improvements during 2003. See Item 8, Note 18(d) to the Consolidated Financial Statements.
In addition, in the years ended December 31, 2005, 2004 and 2003 the Company executed a number of debt and equity transactions which affect the cash flow from financing activities described below in “Capital Resources”.
Revolving credit facilities of $1.2 billion in aggregate. The Company had $45 million outstanding at December 31, 2005, under its syndicated revolving credit facilities and this borrowing was repaid in January 2006. These revolving credit facilities (and their predecessor facilities) were not utilized during 2004. Of the $1.2 billion, $1.0 billion is provided by the Company’s $2.0 billion 3-year syndicated facility that matures in June 2007, and its $2.35 billion 5-year syndicated facility that matures in June 2010. Both facilities provide letters of credit in addition to the revolving credit sublimit. In addition, at December 31, 2005, the Company had two bilateral revolving credit facilities of $100 million each, of which one facility is a 364-day facility that matures in December 2006, and the other is a 5-year facility that matures in August 2010.
$255 million senior notes due April 2011, with a fixed coupon of 6.58%. These notes were privately placed and are not traded on a public exchange.
$350 million senior notes due November 2024, with a fixed coupon of 6.375%. The security is publicly traded. The notes were issued at 100.000% and gross proceeds were $350 million. Related expenses of the offering amounted to $2 million.
The following tables present the Company’s debt under outstanding securities and lenders’ commitments as at December 31, 2005:
In addition to funded debt transactions, the Company and a majority-owned subsidiary (XL Financial Assurance Ltd. (“XLFA”)) have entered into contingent capital transactions. No up-front proceeds were received by the Company or XLFA under these transactions, however, in the event that the associated irrevocable put option agreements are exercised, proceeds previously raised from investors from the issuance of pass-through trust securities would be received in return for the issuance of preferred shares.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company. In connection with this transaction, the fair value of the put premiums and other related costs, in total of $111.9 million was transferred from “Additional paid in capital” to a deferred liability which was established (included with “Other liabilities”) in the consolidated balance sheet at December 31, 2003. The Company amortizes this liability that resulted in an interest expense of approximately $3.5 million in 2004 and $2.0 million in 2003.
(1) Of the total letter of credit facilities above, $1,000 million is also included in the revolvers under notes payable and debt.
It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company, or other financial institutions. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedents. This could take the form of insurance trusts supported by the Company’s investment portfolio or funds withheld (amounts retained by ceding companies to collateralize loss or premium reserves) using the Company’s cash resources or combinations thereof. The face amount of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedents with statutory relief required under state insurance regulation in the U.S.
The following letter of credit facilities were originated or renewed during 2005:
In general, all of the Company’s bank facilities, indentures and other documents relating to the Company’s outstanding indebtedness, including the Credit Facilities discussed above (collectively, the “Company’s Debt
Under the Company’s 364-day facilities, 3-year credit facility, five-year credit facilities placement notes described above, in the event that the Company XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur. The Company currently has an “A+ (stable)” rating from A.M. Best.
Under the Company’s ten-year private placement notes described above, in the event that the Company fails to maintain a financial strength rating of at least “A” from A.M. Best or XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A” from S&P, an event of default would occur. The Company and its subsidiaries currently has an “A+” (stable) rating from A.M. Best and “A+” (stable) S&P.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries in Bermuda fall below a rating of “A-”, the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
The following table presents the Company’s long term contractual obligations and related payments as at December 31, 2005, due by period. This table excludes further commitments of $34.9 million to the Company’s related investment funds, certain limited partnerships, insurance affiliates, collateralized debt/equity investments and letter of credit facilities of $3.5 billion. See Item 8, Note 14 and Note 18 to the Consolidated Financial Statements. See Item 8, Note 13 to the Consolidated Financial Statements for further information.
(3) Future policy benefit reserves on life and annuity business amounted to $5,606,461 on the Company’s Consolidated Balance Sheet at December 31, 2005. Amounts included above include an allowance for future premiums in respect of contracts under which premiums are payable throughout the life of the underlying policy. The value of the discount is also included for those lines of business that have reserves where future claim payments and future premium receipts can be estimated using actuarial principles. The timing and amounts of actual claims payments and premium receipts related to these reserves vary based on the underlying experience of the portfolio. Typical elements of the experience include mortality, morbidity and persistency. The ultimate amount of the claims payments and premium receipts could differ materially from the Company’s estimated amounts.
(4) Contingent capital facilities related payments include an estimate at the payments due under the past option agreement of $200 per month. Actual payments depend on the return on certain assets and LIBOR.
See Item 8, Note 2 to the Consolidated Financial Statements for a discussion on recent accounting pronouncements.
have as a counterparty; (xii) availability of borrowings and letters of credit under the Company’s credit facilities; (xiii) changes in regulation or tax laws applicable to the Company or its subsidiaries, brokers or customers; (xiv) acceptance of the Company’s products and services, including new products and services; (xv) changes in the availability, cost or quality of reinsurance; (xvi) changes in the distribution or placement of risks due to increased consolidation of insurance and reinsurance brokers; (xvii) loss of key personnel; (xviii) the effects of mergers, acquisitions and divestitures; (xix) changes in ratings, rating agency policies or practices; (xx) changes in accounting policies or practices or the application thereof; (xxi) legislative or regulatory developments; (xxii) changes in general economic conditions, including inflation, foreign currency exchange rates and other factors; (xxiii) the effects of business disruption or economic contraction due to war, terrorism or other hostilities; and (xxiv) the other factors set forth in the Company’s other documents on file with the SEC. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere. The Company undertakes no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.
Fixed maturities at fair value (amortized cost: 2005, $31,984,076; 2004, $24,452,348)
Short-term investments, at fair value (amortized cost: 2005, $2,552,589; 2004, $1,738,845)
L I A B I L I T I E S A N D S H A R E H O L D E R S ’ E Q U I T Y
(Loss) Earnings per ordinary share and ordinary share equivalent - basic
(Loss) Earnings per ordinary share and ordinary share equivalent - diluted
These consolidated financial statements include the accounts of the Company and all of its subsidiaries. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated. Certain amounts in 2004 and 2003 have been reclassified to conform to the current year presentation.
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) an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that declines in fair values are other than temporary, the cost of the security is written down to fair value below carrying value and the previously unrealized loss is therefore realized in the period such determination is made.
Credit derivatives are recorded at fair value, which is determined using models 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. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivatives are not traded to realize this resultant value.
For all periods reported herein, the Company amended the presentation of certain credit derivative transactions (described below) in the consolidated statements of income to include certain components of the change in fair value in “gross premiums written”, “net premiums earned” and “net losses and loss expenses incurred”, and in the consolidated balance sheet, certain components of the fair value in “unearned premiums” and “unpaid loss and loss expenses.” Previously, the change in fair value of all of the Company’s derivative transactions was reflected in one line item under “net realized and unrealized gains and losses on derivative instruments”, and the fair value had been reflected in “other assets” and “other liabilities.” There was no effect on net income as a result of this change in presentation and prior period results have been reclassified to reflect this presentation. This change in presentation is applicable only to credit default swaps issued by the Company that are investment grade and that the Company intends, and has the ability, to hold to maturity, and is consistent with practices in the financial guaranty insurance industry for reporting the results of such instruments.
Fair values for the Company’s natural gas contracts are determined through the use of quoted market prices. As quoted market prices are not widely available in the weather and electricity derivative markets, management uses available market data and internal pricing models based upon consistent statistical methodologies to estimate fair values. Estimating the fair value of instruments which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors.
The Company uses investment derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. All interest rate swaps are recorded at fair value. Changes in the value of derivative instruments designated as fair value hedges are recorded as adjustments to the hedged items to the extent that the hedge is effective. Changes in the value of derivative instruments designated as cash flow hedges are recorded in other comprehensive income to the extent that the hedge is effective. The ineffective portion of both fair value and cash flow hedges are recognized in earnings.
Short-term investments comprise investments with a remaining maturity less than one year. Equity securities include investments in open end mutual funds.
All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of equities and fixed income investments are determined on the basis of average cost and amortized cost, respectively. Investment income is recognized when earned and includes interest and dividend income together with the amortization of premium and discount on fixed maturities and short-term investments.
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.
The Company engages in a securities lending program whereby certain securities from the Company’s portfolio are loaned to other institutions for short periods of time. The market value of the loaned securities is monitored on a daily basis, with additional collateral obtained or refunded as the market value of the loaned securities changes. The Company’s policy is to require fixed maturities and initial cash collateral equal to between 102% and 105% of the fair value of the loaned securities depending on the class of assets loaned. The Company continues to earn interest on the securities loaned. In addition, the Company shares a portion of the interest earned on the collateral with the lending agent. The securities lending collateral is included in cash and cash equivalents with a corresponding liability related to the Company’s obligation to return the collateral plus interest included in net payable for investments purchased.
Intangible assets with an indefinite life and goodwill are not amortized. 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 4 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.
The Company estimates the present value of future policy benefits related to long duration contracts using assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation.
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, 2005, 2004 and 2003:
In June 2005, the FASB ratified the Emerging Issues Task Force (“EITF”) Issue No. 04-5, Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights (“EITF 04-5”). The EITF reached a consensus that a sole general partner is presumed to control a limited partnership (or similar entity) and should consolidate the limited partnership unless (1) the limited partners possess substantive kick-out rights or (2) the limited partners possess substantive participating rights similar to the rights described in EITF Issue No. 96-16, Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholders Have Certain Approval or Veto Rights. EITF 04-5 was effective for all new and modified agreements upon the FASB’s ratification in June 2005. For pre-existing agreements that are not modified, the consensus is effective as of the beginning of the first fiscal reporting period beginning after December 15, 2005 and is not expected to have a material impact on the Company’s financial condition or results of operations.
In July 2005, the FASB issued FSP APB 18-1, Accounting by an Investor for Its Proportionate Share of Accumulated Other Comprehensive Income of an Investee Accounted for under the Equity Method In Accordance With APB Opinion No. 18 upon a Loss of Significant Influence (“FSP APB 18-1”), to provide guidance on how an investor should account for its proportionate share of an investee’s equity adjustments for other comprehensive income (“OCI”) upon a loss of significant influence. The FASB believes that an investor’s proportionate share of an investee’s equity adjustments for OCI should be offset against the carrying value of the investments at the time significant influence is lost. To the extent that the offset results in a carrying value of the investment that is less than zero, an investor should (a) reduce the carrying value of the investment to zero and (b) record the remaining balance in income. FSP APB 18-1 became effective during the fourth quarter of 2005 and did not have a material impact on the Company’s financial condition or results of operations.
In August 2005, the FASB issued FSP FAS 123(R)-1, Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R) (“FSP FAS 123(R)-1”), to defer the requirement of FAS 123(R) that a freestanding financial instrument originally subject to FAS 123(R) becomes subject to the recognition and measurement requirements of other applicable GAAP when the rights conveyed by the instrument are no longer dependent on the holder being an employee of the entity. This FSP notes that these instruments should continue to be subject to the recognition and measurement provisions of FAS 123(R) throughout the life of the instrument, unless their terms are modified when the holder is no longer an employee. Following modification, recognition and measurement should be determined through reference to other applicable GAAP. FSP FAS 123(R)-1 became effective during the fourth quarter of 2005 and did not have a material impact on the Company’s financial condition or results of operations.
In November 2005, the FASB issued FSP FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments to finalize the guidance which was initially provided in EITF 03-1, on (1) when an investment is considered impaired, (2) whether that impairment is “other-than-temporary,” (3) how to measure the impairment loss, and (4) disclosures related to impaired securities. Because of concerns about the application of EITF 03-1’s guidance that described whether an impairment is other-than-temporary, the FASB deferred the effective date of that portion of EITF 03-1’s guidance. This FSP now officially nullifies EITF 03-1’s guidance on determining whether an impairment is other-than-temporary, and effectively retains the previous guidance in this area. The FSP generally carries forward EITF 03-1’s guidance for determining when an investment is impaired, how to measure the impairment loss, and what disclosures should be made regarding impaired securities. The guidance is applicable as of January 1, 2006 and is not expected to have a material impact on the Company’s financial condition or results of operations.
In November 2005, the FASB issued FSP FAS 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards to provide a practical transition election related to accounting for the tax effects of share-based payment awards to employees. This FSP stated that either the method outlined previously in FAS 123(R) or the “Short-Cut Method” outlined in the FSP, should be followed to calculate the historical pool of windfall tax benefits upon adoption of FAS 123R. The Short-Cut Method could be used to calculate the beginning balance of the APIC pool related to employee stock options. This FSP is effective as of November 10, 2005 and the Company must decide on whether to make the one-time accounting policy election to calculate the historical pool of windfall tax benefits available using the “short-cut” method as discussed in the FSP or the “long-form” method as outlined in FAS 123R, prior to January 1, 2007. This guidance is not expected to have a material impact on the Company’s financial condition or results of operations.
Following changes in certain executive management responsibilities in January 2005, the Company changed the reporting segments under which certain business units are reported in order to reflect these changes in responsibilities.
Certain blocks of U.S.-based term life mortality reinsurance business previously included in the Financial Products and Services segment are now included in the Reinsurance segment as management of these contracts was transferred to the life reinsurance business units in order to centralize the Company’s management of traditional mortality-based reinsurance business.
All net investment income and net income from affiliates generated by assets and interest expense incurred on liabilities of the business units within the Financial Products and Services segment is reported under financial operations. This income and expense is included in financial operations as it relates to interest on portfolios of separately identified and managed assets and deposit liabilities. Management believes this change better reflects the nature of spread focused business.
One way in which the Company evaluates performance of each segment is based on underwriting results (i.e., underwriting profit or loss) for general operations, net income from life and annuity operations and contribution from financial operations. Other items of revenue and expenditure of the Company are not evaluated at the segment level for general operations. In addition, the Company does not allocate assets by segment for its general operations. Investment assets related to the Company’s life and annuity, and financial operations are held in separately identified portfolios. Net investment income from these assets is included in net income from life and annuity operations and contribution from financial operations, 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. While the Company’s life and annuity reinsurance business is primarily European term assurance, group life, critical illness cover, immediate annuities in payment and disability income business, it is developing a U.S. platform.
This includes net realized gains on investments of $246.5 million and net realized and unrealized gains on investment derivatives of $24.0 million.
As at December 31, 2005 goodwill and other 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.
Effective January 1, 2002, the Company consolidated its investment in Le Mans Ré after increasing its ownership from 49% to 67% in order to expand its international reinsurance operations. Le Mans Ré underwrites a worldwide portfolio comprising most classes of property and casualty reinsurance business, together with a selective portfolio of life reinsurance business. On September 3, 2003, the Company exercised its option to buy the remaining 33% ownership from Les Mutuelles du Mans Assurances Group (“MMA”) for approximately $161 million in cash and changed the name of Le Mans Ré to XL Re Europe. Due to certain contractual arrangements between the Company and MMA, MMA did not have any economic interest in the earnings of XL Re Europe with effect from January 1, 2002 and accordingly, no minority interest was recorded since that date.
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (the “Winterthur Business”) primarily to extend its predominantly North American-based large corporate insurance business globally. The Company provisionally paid to Winterthur Swiss Insurance Company (“WSIC”) $405.6 million at closing for the Winterthur Business based on the audited U.S. GAAP financial statements of the Winterthur Business as at December 31, 2000 and the price was subject to final determination based on the audited U.S. GAAP financial statements of the acquired Winterthur Business operations as at June 30, 2001. In December 2003, the Company reached an agreement with WSIC as to the final purchase price, which was $330.2 million. As a result, $75.4 million in cash was returned to the Company.
Reserve Amount (“SNRA”) and Net Premium Receivable Amount (“NPRA”) were closest to the Independent Actuary’s determinations of SNRA and NPRA. These determinations resulted in the Company receiving a net lump sum payment in the amount of approximately $575.0 million (including interest receivable) from WSIC. As the Company had recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, a loss of approximately $808.9 million, net of interest, was recorded in the fourth quarter of 2005.
In addition, WSIC provides protection to the Company with respect to third party reinsurance receivables and recoverables related to the Winterthur Business, which were $1.6 billion in the aggregate as of December 31, 2005. There are two levels of protection from WSIC for these balances:
2. Under two retrocession agreements the Company has reinsurance protection on the reinsurance recoverables with respect to the SNRA determined as of June 30, 2004 to the extent that the Company does not receive payment of such amounts from applicable reinsurers with one agreement providing a limit of $1.3 billion for the insurance written in the period to June 30, 2001 and the other agreement providing a limit of $1.3 billion for the insurance written in the period to December 31, 2000.
The Company recognized goodwill in excess of the fair value of the net assets of the acquired Winterthur International insurance operations to increase its global platform for its insurance operations.
Net realized gains and losses in 2005 and 2004 included a loss of $53.2 million and $6.4 million, respectively, relating to certain fixed income, equity securities and other investments where the Company determined that there was an other than temporary decline in the value of those investments.
The Company has gross unrealized losses which it considers to be temporary impairments. Individual security positions comprising this balance have been evaluated by management, based on specified criteria, to determine if these impairments should be considered other than temporary. These criteria include an assessment of the severity and length of time securities have been impaired, along with management’s ability and intent to hold the securities to recovery, among other factors. At December 31, 2005, there were $312.7 million of gross unrealized losses on fixed income and short-term investments, and $8.8 million of gross unrealized losses on equity securities. 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, 2005, approximately 2.4% of the Company’s fixed income investment portfolio was invested in securities which were below investment grade or not rated. 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. Approximately 4.3% of the unrealized losses in the Company’s fixed income securities portfolio at December 31, 2005 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, 2005 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 Company has invested in certain closed end funds, certain limited partnerships, LLC’s and similar investment vehicles, including funds managed by certain of its investment management affiliates. At December 31, 2005 and 2004, investments in affiliates were $1.7 billion of which $1.5 billion was included in the alternative investment portfolio and $0.2 billion consisted of private investments.
The Company’s significant financial affiliate investments at December 31, 2005 included Primus Guaranty, Ltd. with ownership of 31%.
During 2005, the Company recorded other than temporary loss in the value of One Capital Management Partners of $2.5 million. The net income from insurance affiliates in 2004 included 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.
During 2005, the insurance segment’s net adverse prior year development of $1.02 billion includes $834.2 million of incurred loss related to the conclusion of the independent actuarial process with WSIC. Excluding this development the remaining $185.8 million was driven primarily by increases in reported case reserves for excess professional liability. Strengthening of $259.5 million in professional lines was caused primarily by the establishment of case reserves on both directors’ and officers’ claims in pre-2002 business, and errors and omissions claims.
During 2004, net prior year reserves across the Reinsurance Segment developed favorably by $24 million. Releases of $144 million net in the property, aviation, marine and other lines of business were partially offset by strengthening of casualty and accident and health reserves amounted to approximately $120 million. Property catastrophe and property other reserve releases totaled approximately $95 million net related primarily to the 2002 and 2003 underwriting years where loss experience has been exceptionally good for the property line. The strengthening of casualty reserves totaled $75 million and related most significantly to professional liability reserves in the London branch which were strengthened by $32 million for Enron and Worldcom claims. The accident & health reserve strengthening of $45 million relates to a portfolio of business underwritten by certain of the Company’s Lloyd’s syndicates
As a result of the new information obtained in the claims audit review, the Company performed a supplemental analysis of its North American casualty reinsurance lines of business specific to the nature of individual cedent’s circumstances. The Company separately reviewed the historical loss development of its major cedents using several actuarial methodologies; where the analysis of a cedent’s experience concluded that the experience was worse than the Company’s historical loss development experience, the Company projected that cedent’s ultimate loss based on the cedent’s own experience. In addition, the Company assumed that the more recent experience was more indicative of future loss development by selecting development patterns that were based on the most recent experience rather than on the Company’s or cedent’s longer term historical experience.
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 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 any prior year development amount.
The Company’s net unpaid losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2005 and 2004, the reserve for potential non-recoveries from reinsurers was $260.7 million and $279.0 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% (2004: 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. The effect of the decrease in the interest rate resulted in an increase in loss reserves of approximately $35.0 million in 2003. 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, 2005 and 2004 were $716.7 million and $578.6 million, respectively. The related discounted unpaid losses and loss expenses were $322.2 million and $290.0 million as of December 31, 2005 and 2004, respectively.
Incurred but not reported losses, net of reinsurance, included in the above table was $16.7 million in 2005, $22.5 million in 2004 and $27.0 million in 2003. Unpaid losses recoverable are net of potential uncollectible amounts.
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 reported asbestos claims related to both traditional products and premises and operations coverage.
Included in unpaid loss and loss expenses recoverable at December 31, 2004, was an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (the “WSIC”) of $1.45 billion, related to certain contractual arrangements in the sale and purchase agreement (“SPA”), as amended, relating to the Company’s acquisition of certain Winterthur International insurance operations (the “Winterthur Business”) in July 2001. The conclusion of the Independent actuarial process resulted in the Company receiving a net lump sum payment for 2005, in the amount of approximately $575.0 million, net of interest.
In addition, WSIC provides protection to the Company with respect to third party reinsurance receivables and recoverables related to the Winterthur Business, which are $1.6 billion in the aggregate as of December 31, 2005. There are two levels of protection from WSIC for these balances:
Under two retrocession agreements the Company has reinsurance protection on the reinsurance recover- ables with respect to the Seasoned Net Reserves Amount determined as of June 30, 2004 to the extent that the Company does not receive payment of such amounts from applicable reinsurers with one agree- ment 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.
Interest expense of $227.7 million, $143.6 million and $105.1 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2005, 2004 and 2003, respectively.
During 2005 and 2004, the Company entered into long duration contracts that subject the Company to mortality and morbidity risks and which were accounted for as life premiums earned. Future policy benefit reserves were established using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The average interest rate used for the determination of the future policy benefits for these contracts was 4.8% and 5.1% at December 31, 2005 and 2004, respectively. Total future policy benefit reserves for the year ended December 31, 2005 and 2004 were $5.6 and $4.3 billion, respectively. Substantially all of these reserves relate to closed blocks of annuities.
As at December 31, 2005, the Company had bank and loan facilities available from a variety of sources, including commercial banks, totaling $4.6 billion (2004: $3.4 billion) of which $3.4 billion (2004: $2.7 billion) of debt was outstanding. In addition, the Company has letter of credit facilities totaling $5.5 billion available of which $3.5 billion (2004: $3.0 billion) were outstanding as at December 31, 2005, 5.3% (2004: 6.6%) of which were collateralized by the Company’s investment portfolio, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements. Of these amounts, $1.0 billion is available in the form of revolving credit or letters of credit.
(1) “Commitment” and “In Use” data represent December 31, 2004 accreted values.
$45 million was drawn under the syndicated revolving credit facility at December 31, 2005 at an average interest rate in 2005 of 4.5%, and this amount was repaid in January 2006. There were no borrowings or repayments under the Company’s revolving credit facilities during 2004.
In December 2005, the Company created a new $100 million unsecured bilateral credit facility that was unutilized during 2005 and at December 31, 2005. The full amount of $100 million is available as both revolving credit and letters of credit, with the combined total not to exceed $100 million.
In connection with this transaction, $36.9 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 $23.9 million total costs associated with the issuance of the 7.0% Units, $21.1 million was charged to “Additional paid in capital” with the remainder deferred and amortized over the term of the senior debt.
In September 2005, the Company renewed an unsecured bilateral credit facility of $150 million (previously $200 million) that was fully utilized at December 31, 2005.
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 was available as revolving credit and up to $3.0 billion was available in the form of letters of credit, with the combined total not to exceed $3.0 billion. As at December 31, 2004 approximately $1.9 billion of the 3-year facility was in use in the form of letters of credit while the 364-day facility was unutilized at that date.
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 redeem the Zero Coupon Convertible Debentures (“CARZ”) as described below.
In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”). These facilities were increased to $500.0 million in June 2003. The proceeds of advances under the Credit Facilities were used to fund a trust account to collateralize the reinsurance obligations of the Company. The Company could face additional obligations under the Credit Facilities prior to the stated maturity of February 25, 2008, if certain events were to occur, including, but not limited to the Company’s insolvency, withdrawal of assets from the Regulation 114 trust by the ceding company, the downgrade of the Company’s credit ratings below certain specified levels, or the failure of the agent to have a first priority perfected security interest in the collateral posted by the Company. At maturity, the Company will be obligated to make payments in an amount equal to the principal and accrued interest outstanding under the Credit Facilities. The issued securities and the Company’s repayment obligations are recorded as a net balance on the Company’s balance sheet.
In December 2004, XL Financial Assurance Ltd. (“XLFA”) entered into a put option agreement and an asset trust expense reimbursement agreement with Twin Reefs Asset Trust (the “Asset Trust”). The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase XLFA’s non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. XLFA is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B Preferred Shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the asset trust expense reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 9, 2009, or under certain defined circumstances, such as the failure of XLFA to pay the put option premium when due or bankruptcy. The put option is recorded at fair value with changes in fair value recognized in earnings.
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. The commercial facilities are scheduled for renewal during 2006 through 2010. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedents with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other
The following table summarizes insurance activities related to credit default swap derivative instruments excluding gains and losses on credit default swaps within the investment portfolio.
The change in fair value recorded for the weather and energy derivatives was a gain of $17.8 million, $2.0 million and $1.1 million for the years ended December 31, 2005, 2004 and 2003, 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, 2005, $30.3 million of net realized and unrealized losses related to these foreign exchange forward contracts and were included in the cumulative translation adjustment. As at December 31, 2005 the net unrealized gain position of these contracts was $13.4 million on a total contract value of $141.2 million. 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.
In 2002, the Company entered into a treasury rate lock agreement with the underwriters of the 6.50% Guaranteed Senior Notes due 2012 (2001: 6.58% Guaranteed Senior Notes due 2011). The Notes were priced using a margin over the yield of a U.S. Treasury note with a similar maturity. The treasury rate lock agreement was designed to eliminate underlying pricing risk of the Company’s debt that would have resulted from an increase in the yield of the comparable U.S. Treasury issue between the initiation of the transaction and the pricing of the transaction. The total cost of the hedge was $4.2 million. In 2001, a loss of $5.6 million was recorded in net realized and unrealized
gains and losses related to the cancellation of the treasury lock agreement relating to the 6.58% notes due 2011 due to the September 11, 2001 event.
The following tables presents financial guaranty aggregate insured portfolios at December 31, 2005 where the net par outstanding was $88.3 billion, which includes credit default swap exposures of $14.7 billion. The net principal and interest insured, as of December 31, 2005 and 2004 was $130.8 billion and $108.3 billion, respectively. The liability for these credit derivatives had a carrying value of $31.5 million and $38.2 million at December 31, 2005 and 2004, 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 the three years ended December 31, 2005, 2004 and 2003, approximately 21%, 22% and 24%, respectively, of the Company’s consolidated gross written premiums from general operations were generated from or placed by Marsh & McLennan Companies. During 2005, 2004 and 2003, 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, 2005, 2004, or 2003.
The Company’s available for sale investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification, which limit the allowable holdings of any single issue. The Company did not have an aggregate investment in a single entity, other than the U.S. Government, in excess of 10% of the Company’s shareholders’ equity at December 31, 2005, 2004, or 2003.
Under two retrocession agreements the Company has reinsurance protection on reinsurance recoverables with respect to the seasoned net reserved amount 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.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. As of December 31, 2005, the Company has commitments which include potential additional add-on clauses, to invest a further $1.8 million over the next five years.
The Company owns a minority interest in certain closed-end funds, certain limited partnerships and similar investment vehicles, including funds managed by those companies. The Company has commitments, which include potential additional add-on clauses, to invest a further $33.0 million over the next five years.
The Company rents space for certain of its offices under leases that expire up to 2022. Total rent expense under operating leases for the years ended December 31, 2005, 2004 and 2003 was approximately $34.9 million, $31.2 million and $42.3 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
In November 2002, the Company issued 11.5 million 7.625% Series B Preference Ordinary Shares at $25 per share. Gross proceeds were $287.5 million and related expenses were $9.1 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after November 18, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the Preference Shares before November, 2007 at specified redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference
The Company's 1999 Performance Incentive Program for Employees (the “1999 Program”) provides for grants of non-statutory stock options, restricted stock, performance shares and performance units to employees of the Company and its subsidiaries who are not subject to the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934. The 1999 Program is administered by the Board of Directors of the Company or the Compensation Committee, as determined from time to time by the Board of Directors.
Restricted stock awards issued under the 1991 and 1999 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 these plans totaled 895,484 shares, 660,535 shares, and 500,432 shares in 2005, 2004, and 2003, respectively.
Prior to December 31, 2003, all options granted to non-employee directors were granted under the 1991 Performance Incentive Program. In 2004, these options were granted under the Directors Stock & Option Plan. All options vest immediately on the grant date. Directors may also make an irrevocable election preceding the beginning of each fiscal year to defer cash compensation that would otherwise be payable as his or her annual retainer in increments of 10%. The deferred payments are credited in the form of ordinary share units calculated by dividing 110% of the deferred payment by the market value of the Company’s stock on the date the compensation would otherwise have been paid. These shares are distributed under the terms of the plan. Shares issued under the plan totaled 3,814, 3,819, and 3,153 in 2005, 2004 and 2003, respectively.
10,027, 8,351, and 8,598 were issued in 2005, 2004 and 2003, respectively. Total units are granted as shares upon retirement from the Board.
The Employee Share Purchase Plan (the “ESPP”) was approved by the shareholders of the Company on May 10, 2002; however, the Company has discontinued the ESPP effective January 1, 2006. The ESPP was administered by a committee which consisted of members of the Compensation Committee of the Company’s Board of Directors. The ESPP had two offering periods a year. The first period commenced on July 1, 2002. All employees of the Company and its designated participating subsidiaries, were eligible to participate in the ESPP provided they have been employed at least one month prior to the start of the offering period and they do not hold more than 5% of the Company’s total stock, including stock acquired in the current period. Employees could invest up to 20% of their total monthly cash compensation towards the purchase of the Company’s shares up to a total market value (measured on the first day of the offering period) of U.S. $25,000. The total number of shares purchased in any offering period cannot exceed 1,000 shares. Employees who enrolled in the ESPP may purchase the Company’s shares at a 15% discount on the lesser of the market price at the beginning or at the end of the six month offering period. Once purchased, employees can sell or transfer their shares to someone else’s name only during an Open Trading Window. Participants in the ESPP are eligible to receive dividends on the Company’s shares. A total of 1,255,000 ordinary shares may be issued under the ESPP. The number of share issued during the years ended December 31, 2005 and 2004 were 114,177 and 167,890, respectively.
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2005 and 2004 is provided below:
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2005 and 2004 were as follows:
The valuation allowance at December 31, 2005 and December 31, 2004 of $154.5 million and $68.6 million, respectively, relates to net operating loss carry forwards in Switzerland and Australia and net unrealized capital losses and realized capital loss carry forwards in the U.S. that may not be realized within a reasonable period. As of December 31, 2005, the Company has net unrealized capital losses and realized capital loss carry forwards of approximately $56.2 million and $22 million respectively in the U.S., against which a valuation allowance of $23.7 million has been established. Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized.
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.
Shareholders’ equity at December 31, 2005 and 2004 reflected tax benefits of $1.8 million and $3.6 million, respectively, related to compensation expense deductions for stock options exercised by the Company’s U.S. subsidiaries.
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, based on draft unaudited filings for the principal operating subsidiaries of the Company for the year ended December 31, 2005 was as follows. The comparative figures at December 31, 2004 are the final audited figures submitted to the regulators.
Except as noted below, there are no statutory restrictions on the payment of dividends from retained earnings by any of the Company’s subsidiaries as applicable minimum levels of solvency and liquidity have been met and all regulatory requirements and licensing rules complied with. At December 31, 2005, and 2004 (XLRA), the Company’s lead property and casualty subsidiary in the United States, had a statutory deficit of $3.6 million and $84.4 million, respectively. As a result, XLRA cannot declare or distribute any dividends to shareholders during any twelve month period that exceeds the lesser of 10% of surplus of 100% of net investment income, without obtaining prior approval of the New York Insurance Department. Similarly, three of the seven property and casualty subsidiaries directly or indirectly owned by XLRA also had statutory deficits ranging from $13.2 million to $46.9 million at December 31, 2005 and four of the seven had statutory deficits ranging from $0.2 million to $57.4 million at December 31, 2004. As a result, these subsidiaries are similarly unable to currently make a dividend distribution under the insurance law of their respective states of domicile without obtaining prior approval from the domicile insurance department, which include Delaware, New York and North Dakota. At December 31, 2005 and 2004, XL Insurance Company Limited (previously known as Winterthur International Insurance Company Limited) had a statutory earned deficit and is restricted from making a dividend distribution at this time under U.K. Company law.
Certain reclassifications have been made relating to the Company’s change in presentation of financial operations. There was no effect on net income from this change in presentation.
In the third quarter of 2005, the Company recorded net loss and loss expenses of $1.5 billion in relation to Hurricanes Katrina and Rita and other natural catastrophes. In the fourth quarter of 2005 that loss estimate was increased by $165.1 million. In addition a loss of $808.9 million was recorded in the fourth quarter of 2005 in relation to the conclusion of the independent actuarial process with Winterthur Swiss Insurance Company.