Preference share dividends represent dividends on the Redeemable Series C preference ordinary shares and the Series D and E preference ordinary shares issued by XLIT. The Redeemable Series C preference ordinary shares and the Series D and E preference ordinary shares represent non-controlling interests in our consolidated financial statements. For additional information see Item 8, Note 19, "Share Capital," to the Consolidated Financial Statements.
Represents a non-GAAP financial measure as discussed in Item 7, "Management's Discussion and Analysis - Reconciliation of Non-GAAP Measures."
This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes thereto presented under Item 8.
downward movement in rates for property and casualty insurance and reinsurance;
the impact of recent tax reform on our business, investments and assets, including the following potential impacts of the U.S. Tax Cuts and Jobs Act: (i) changes to valuation of deferred tax assets and liabilities; (ii) higher costs associated with such tax reform than expected; (iii) the risk that technical corrections, regulations, and supplemental legislation and future interpretations or applications thereof may be issued in the future or (iv) the risk that other changes may be issued in the future, including the rules affecting the valuation of deferred tax assets;
the availability, cost or quality of ceded reinsurance, and the timely and full recoverability of such reinsurance, or other amounts due to us, or changes to our projections related to such recoverables;
increased competition on the basis of pricing, capacity, coverage terms or other factors, such as the increased inflow of third party capital into reinsurance markets, which could harm our ability to maintain or increase business volumes or profitability;
greater frequency or severity of claims and loss activity than our underwriting, reserving or investment practices anticipate based on historical experience or industry data, including due to the change in climate conditions;
the ability of our subsidiaries to pay dividends to XL Group, XLIT and Catlin Insurance Company Ltd;
the economic, political, monetary, and operational impacts of Brexit, including unanticipated costs or complications associated with our decision to redomesticate XL Insurance Company SE from the U.K. to Ireland, or the possibility that this redomestication or other Brexit-related decisions do not have the results anticipated;
changes in general economic, political or monetary conditions in Euro-Zone countries or emerging markets, or governmental actions for the purposed of stabilizing financial markets;
We are, through our subsidiaries, a global insurance and reinsurance company providing property, casualty and specialty products to industrial, commercial and professional firms, insurance companies and other enterprises on a worldwide basis. We operate in markets where we believe our underwriting expertise and financial strength represent a relative advantage. We earn revenue primarily from net premiums written and earned. For further information regarding our operations, see Item 1, "Business."
The reinsurance market continues to see a meaningful influx of third party capital from new and existing market participants, particularly in the property catastrophe space, and has begun to expand into other lines of business, which we expect to continue going forward. With this additional capital, the traditional market has seen many changes including sizable increases in the overall global limits being provided, multi-year terms, and new aggregate structures, as well as a meaningful increase in the number of alternative types of structures being provided. The market has experienced excess capacity as supply from both traditional markets and third party capital continued to outpace reinsurance demand. The increased capacity has resulted in further pricing reductions, enhanced commissions and expanded coverage at attractive terms for insurers across most lines of business. The market also saw insurers combining separate regional programs or specialty and casualty sub lines into single global multi-line programs to get even further pricing improvements and expansion of terms and conditions. In addition, with the strengthened balance sheets of insurers and their push for expense savings to improve their bottom line, the reinsurance market has seen increased retentions by insurers and a focus on maximizing their spend on reinsurance with a highly selective panel of reinsurers, particularly in the case of some larger insureds.
growth in both segments despite tough market conditions, without sacrificing quality, as evidenced by our loss and combined ratios excluding the effects of prior year development and natural catastrophe activity. Efforts continued as well to refine our portfolios to maintain profitable business while exiting certain underperforming businesses. The following outlines some of these initiatives as well as recent renewal activity and January 2018 rate indications for both of our segments, in light of the recent catastrophic events together with other potential material trends or uncertainties relevant to our P&C operations.
The pricing headwinds that have been endured since 2015 have finally stalled in light of the industry’s 2017 catastrophe losses, and there is clear evidence of a changing market. For the year ended December 31, 2017, rates overall were down approximately 1% compared to down 2.6% in the corresponding prior year period, and for the three months ended December 31, 2017, pricing in the Insurance segment was up nearly 1% reflecting the first quarterly increase since the fourth quarter of 2014.
Gross premiums written in the year were up by 4.4%, or $420 million on a reported basis compared to the prior year, and when we normalize for foreign exchange, up by nearly 5% for the year. Our largest growing portfolios included our International property, casualty and financial lines books, our North America construction, property and global risk management books, as well as our Global Lines fine art & specie, accident & health and political risk, credit and bond businesses. See "Income Statement Analysis - Insurance," for further discussion of our premium movements.
The trading environment for our core lines of insurance business is showing evidence of broad and more sustainable rate improvements. Despite January 1, 2018 renewal rates being somewhat dampened by pre-storm and multi-year renewals, we are seeing rate increases in the 3-4% range for the segment as a whole and fully expect rate increases to continue in upcoming renewals as we lead this change in the market. We will continue to focus on those lines of business that we believe provide the best return on capital. Through continued expense management, improvements in business mix, on-going underwriting actions, and increased efficiency in our use of reinsurance, we remain committed to improving our margins in the coming year.
For the recently completed January 1 renewals, rates were positive 4.7% across the portfolio. Property catastrophe rates globally increased by 6.4% with international rates up 3.2% and U.S. rates increasing by 8.5%. Rates on our casualty treaty book were up 4.8% and rates on the remainder of the business were directionally encouraging.
Contrary to initial expectations, inflationary pressures continued to be subdued during most of the year. Commodity prices were a headwind to inflation in the first half of the year and several idiosyncratic factors (e.g. telecom prices) also negatively weighted on U.S. inflation. Towards the end of the year, the recovery in commodity prices and uptick in producer prices lent
The year also marked a shift in monetary stimulus, as several central banks around the world started to unwind parts of the stimulus previously provided. The Bank of England raised interest rates for the first time since the financial crisis, the U.S. Federal Reserve ("Fed") managed to execute three interest rate increases in the period and also announced a timetable for its balance sheet reduction, and the ECB reduced the volume of its asset purchase program.
In an environment of positive growth and recovery in inflation, we expect central banks around the world to continue to unwind monetary stimulus. The Fed is expected to raise interest rates at least three times in the year, and the ECB is expected to allow quantitative easing to expire and also provide a roadmap for the first rate increases since 2011. On the fiscal front, as deficit pressures are reduced, fiscal policy will not be a headwind to growth, including in the U.S., given the recently announced tax cuts.
Net investment income - P&C operations includes all net investment income related to the net results from structure products and excludes all net investment income from the assets supporting the Life Funds Withheld Assets, as defined in Item 8, Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation.
The underwriting expense ratio related to the P&C operations is the sum of acquisition costs and operating expenses for the Insurance and Reinsurance segments divided by net premiums earned for the Insurance and Reinsurance segments.
2017 vs. 2016: The decreases in our net income, basic EPS and diluted EPS for the year ended December 31, 2017 were attributable to the movements in our underwriting profit and combined ratio as discussed above, as well as a one-time tax charge of $100.5 million related to the revaluation of our net deferred tax asset as a result of the reduced U.S. corporate income tax rate as part of the U.S. Tax Cuts and Jobs Act.
Operating net income is a non-GAAP financial measure defined as net income (loss) attributable to common shareholders excluding: (1) our net investment income - Life Funds Withheld Assets, (2) our net realized (gains) losses on investments sold - excluding Life Funds Withheld Assets, (3) our net realized (gains) losses on investments sold (including OTTI) and net unrealized (gains) losses on investments, Trading - Life Funds Withheld Assets, (4) our net realized and unrealized (gains) losses on derivatives, (5) our net realized and unrealized (gains) losses on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets, (6) our share of items (2) and (4) for our insurance company affiliates for the periods presented, (7) our foreign exchange (gains) losses, (8) our expenses related to the acquisition of Catlin Group Limited ("Catlin") completed on May 1, 2015 ("Catlin Acquisition"), (9) our gain on the sale of our interest in ARX Holding Corp., (10) our gain on the sale of our wholly-owned subsidiary XL Life Insurance and Annuity Company and the partial sale of our holdings in New Ocean Capital Management, (11) our loss on the inception of the U.S. Term Life Retro Arrangements, (12) our net (gains) losses on the early extinguishment of debt, (13) our net (gains) losses from the repurchase of preference shares, (14) tax provision arising from our write-down of our deferred tax asset related to the U.S. Tax Cuts and Jobs Act, and (15) a provision (benefit) for income tax on items excluded from operating income.
Although the investment of premiums to generate income (or loss) and realized capital gains (or losses) is an integral part of our operations, the determination to realize capital gains (or losses) is independent of the underwriting process. In addition, under applicable GAAP accounting requirements, losses can be recognized as the result of other-than-temporary declines in value and from goodwill impairment charges without actual realization. In this regard, certain users of our financial information, including certain rating agencies, evaluate earnings before tax and capital gains to understand the profitability of the operational sources of income without the effects of these two variables. Furthermore, these users believe that, for many companies, the timing of the realization of capital gains is largely a function of economic and interest rate conditions.
Net realized and unrealized (gains) losses on derivatives include all derivatives entered into by the Company other than certain credit derivatives and the life retrocession embedded derivative. With respect to credit derivatives, because the Company and its insurance company operating affiliates generally hold financial guaranty contracts written in credit default derivative form to maturity, the net effects of the changes in fair value of these credit derivatives are excluded (similar with other companies' treatment of such contracts), as the changes in fair value each quarter are not indicative of underlying business performance.
Foreign exchange (gains) losses in the Consolidated Statements of Income are only one element of the overall impact of foreign exchange fluctuations on XL's financial position and are not representative of any economic gain or loss made by the Company. Accordingly, they are not considered a relevant indicator of financial performance and are excluded.
In summary, we evaluate the performance of and manage our business to produce an underwriting profit. In addition to presenting net income (loss), we believe that showing operating net income (loss) enables investors and other users of our financial information to analyze our performance in a manner similar to how we analyze our performance. In this regard, we believe that providing only a GAAP presentation of net income (loss) would make it more difficult for users of our financial information to evaluate our underlying business. We also believe that equity analysts and certain rating agencies that follow us (and the insurance industry as a whole) exclude these items from their analyses for the same reasons, and they request that we provide this non-GAAP financial information on a regular basis. A reconciliation of our net income (loss) attributable to common shareholders to operating net income (loss) is provided at "Reconciliation of Non-GAAP Financial Measures" below.
2017 vs. 2016: The decrease in operating income is principally attributed to the significant natural catastrophe activity as noted above.
Return on average common shareholders' equity ("ROE") and other non-GAAP ROE-derived measures
ROE is calculated by dividing the annualized net income (loss) attributable to common shareholders for any period by the average of the opening and closing shareholders' equity attributable to XL Group ("common shareholders' equity"). We establish minimum target ROEs for our total operations, segments and lines of business. If our minimum ROE targets over the longer term are not met with respect to any line of business, we seek to modify and/or exit this line.
Operating return on average common shareholders' equity excluding integration costs and AOCI ("Operating ROE ex-integration and AOCI") is an additional non-GAAP financial measure of our profitability that combined the effects of the two metrics discussed above. Operating ROE ex-integration costs and AOCI is derived by dividing non-GAAP operating net income excluding integration costs for any period by the average of the opening and closing common shareholders' equity excluding AOCI.
2016 vs. 2015: The decreases in our Operating ROE metrics were due mainly to the increased natural catastrophe activity as noted above.
We view the change in our book value per common share ("BVPS") and fully diluted book value per share ("Fully diluted BVPS") as additional measures of our performance, representing the value generated for our common shareholders each period, and we believe that these measures are key drivers of our share price over time. BVPS is calculated by dividing common shareholders' equity by the number of outstanding common shares at the applicable period end. Common shares outstanding include all common shares issued and outstanding (as disclosed on the face of the Consolidated Balance Sheets) as well as all director share units outstanding. Fully diluted BVPS is calculated by dividing common shareholders' equity by the number of outstanding shares at the applicable period end combined with the impact from dilution of share-based compensation and certain conversion features where dilutive. BVPS and Fully diluted BVPS are affected primarily by net income (loss), by any changes in the net unrealized gains and losses on our investment portfolio, by currency translation adjustments and by the impact of any share buyback or issuance activity. Common shares outstanding include all common shares issued and outstanding (as disclosed on the face of the Consolidated Balance Sheets) as well as all director share units outstanding.
2017 vs. 2016: The decreases in our BVPS, Fully diluted BVPS and Fully diluted TBVPS were mainly due to the lower net income discussed above, plus the effects of preferred and common dividends during the year, as well as the effect of the share buyback activity, partially offset by the increase in our unrealized gains on investments.
2016 vs. 2015: The increases in our BVPS, Fully diluted BVPS and Fully diluted TBVPS were primarily a result of common share buyback activity during the year. Additionally, we added positive net income, net of dividends paid, for the year to our retained earnings.
Reconciliations of these measures and their components are provided under "Reconciliation of Non-GAAP Financial Measures" below.
The tax impact was calculated at the applicable jurisdictional effective tax rate, which could differ from the Company’s effective tax rate.
The following table outlines the underwriting losses and loss ratio impact for the Insurance and Reinsurance segments from natural catastrophes for the years ended December 31, 2017, 2016 and 2015:
2016 - included Hurricane Matthew on the Southeast coast of the U.S. ($130.1 million), wildfires around Fort McMurray, Alberta, Canada ($101.2 million), earthquakes in New Zealand ($75.0 million), Ecuador ($17.3 million) and Japan ($10.7 million), flooding in Louisiana ($23.0 million) and West Virginia ($11.5 million), Typhoon Meranti in the Phillippines ($18.7 million) and a combination of other storms across Europe and the U.S.
Our loss estimates are based on combinations of our review of individual treaties and policies expected to be impacted, commercial model outputs, client data received through the date the estimates are made, and consideration of expectations of total insured market loss estimates, if available, both from published sources and our internal analysis. Our loss estimates involve the exercise of considerable judgment due to the complexity and scale of the insured events, and are, accordingly, subject to revision as additional information becomes available. Actual losses may differ materially from these estimates.
Prior year development occurs when there is a change recorded during the year to the ultimate loss of a prior accident year. Favorable prior year development occurs when there is a decrease recorded during the year to the ultimate loss of a prior accident year. Adverse prior year development occurs when there is an increase recorded during the year to the ultimate loss of a prior accident year.
Market movement impacts on the Company's investment portfolio (Excluding Life Funds Withheld Assets)
We closed the Catlin Acquisition on May 1, 2015. Management was highly focused on successfully integrating Catlin and realizing the anticipated synergies associated with this significant acquisition. Following the initial announcement of the proposed transaction, management developed a comprehensive integration plan that identified key areas of focus and action plans in anticipation of closing and implemented that plan following the closing of that transaction. The recognition of integration costs related to the Catlin Acquisition was completed in the second quarter of 2017.
Fundamental to supporting our business model is our ability to underwrite business, which is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that we are downgraded, our ability to write business, as well as our financial condition and/or results of operations, could be adversely affected. Managing our capital, debt and leverage is an important part of maintaining the necessary ratings positions.
October 1, 2017 net risk exposure levels were impacted by the interaction of the significant natural catastrophe events in August and September as noted in "Significant Items Affecting the Results of Operations," with our various risk transfer programs, as well as the benefit of additional reinsurance purchased in September 2017. While total available limits were eroded by these events, remaining protection was more responsive for future events due to erosion of aggregate deductibles.
We actively evaluate and manage our net exposure profile, and continued to do so through the end of 2017 and into 2018. Our net exposure profile reflects the seasonality of exposure, events that have occurred earlier in the year and the economics of various risk transfer mechanisms.
The table below shows our estimated per event probability exposures for certain peak natural catastrophe peril regions based on our evaluation and detailed analysis with a measurement date of October 1, 2017, adjusted to include reinsurance programs in place as of January 31, 2018. These estimates assume that amounts due from reinsurance and retrocession purchases are 100% collectible. There may be credit or other disputes associated with these potential receivables.
Negotiations to determine the terms of the U.K.'s withdrawal from the E.U. by March 2019 under article 50 of the Treaty on European Union, as well as the U.K's relationship with the E.U. and individual E.U. member states post-Brexit, have commenced, but remain largely unresolved.
While Brexit did not materially affect our financial condition or results of operations for the year ended December 31, 2017, we anticipate that Brexit will disrupt our U.K. domiciled entities', including our Lloyd's syndicates', ability to "passport" within the E.U. Passporting means that an E.U.-domiciled entity can write insurance or reinsurance in another E.U. member state while only being regulated by the regulator in its country of domicile. As a consequence, on September 19, 2017, we announced our plan to redomesticate our principal E.U. insurance company, XL Insurance Company SE ("XLICSE") to Ireland in 2018, subject to certain regulatory approvals. The redomestication will result in XLICSE remaining in the E.U. post Brexit so that it can continue to benefit from passporting through its branch network within the E.U.
Currently, Lloyd's is wholly reliant on the passporting regime to do business across the E.U. On March 29, 2017, Lloyd's announced that it intends to set up a new insurance company in Brussels, Belgium, to serve as an E.U. hub post-Brexit, which it anticipates will commence operations in January 2019. Given that we are one of the largest underwriting syndicate at Lloyd's, management is closely monitoring Lloyd's ability to successfully implement its post-Brexit strategy with the E.U.
The following are considered to be our 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 could 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 our results of operations, financial condition and liquidity. We have discussed these critical accounting policies with the Audit Committee of the Board of Directors.
The table below illustrates the amount of our net unpaid losses and loss expenses relating to our operating segments at December 31, 2017 and 2016 by line of business. For further discussion of our reserving methodologies for Case and IBNR reserves, see Item 8, Note 10, "Losses and Loss Expenses," to the Consolidated Financial Statements included herein.
Other within the Reinsurance segment includes multiline, whole account contracts, credit and surety, accident and health and other lines.
Furthermore, statistical distributions of potential reserve outcomes over a one year run-off period were estimated for the granular lines of business. Where appropriate, within each line of business, any losses exhibiting differing nature of volatility, for example, in respect of attritional, large, catastrophe, clash and threat (low frequency and high severity) losses were analyzed and then aggregated using an appropriate correlation assumption. In doing so, we evaluated a number of alternative models, and for each line of business, our actuaries selected the distribution parameters deemed to be most appropriate. Factors affecting this decision included an assessment of the model fit, availability and relevance of data and the impact of changes in business mix. We used the modeled statistical distribution to calculate an 80% prediction interval for the potential reserve outcomes over this one year run-off period.
The Estimated High and Estimated Low net unpaid loss and loss expenses are drawn from the resulting statistical distributions as the 90th percentile and 10th percentile, respectively. Accordingly, given the uncertainty in experience over the next 12 months, there is an 80% chance that the net earned claim reserves (including claims expenses) as of December 31, 2017 will be between the Estimated High and Estimated Low figures provided in the table. Additionally, there is a 10% chance that this valuation will be higher than the Estimated High figure and a 10% chance that this valuation will be lower than the Estimated Low figure.
At December 31, 2017, gross future policy benefit reserves relating to our Run-Off Life Operations were approximately $3.6 billion, of which we retained $168.3 million, after consideration of all of our future policy benefit reserves recoverable, as discussed in Item 8, Note 11, "Future Policy Benefit Reserves," to the Consolidated Financial Statements included herein.
Our process for identifying declines in the fair value of investments that are other-than-temporary involves consideration of several factors. The primary factors include: (i) an analysis of the liquidity, business prospects and financial condition of the issuer, including consideration of credit ratings; (ii) the significance of the decline; (iii) an analysis of the collateral structure and other credit support, as applicable, of the securities in question; and (iv) for debt securities, whether we intend to sell such securities. In addition, the authoritative guidance requires that OTTI for certain asset backed and mortgage backed securities are recognized if the fair value of the security is less than its discounted cash flow value and there has been a decrease in the present value of the expected cash flows since the last reporting period. Where our analysis of the above factors results in our conclusion that declines in fair values are other-than-temporary, the cost of the security is written down to discounted cash flow, and a portion of the previously unrealized loss is thereby realized in the period such determination is made.
new issues that may adversely impact our investment portfolio, and review any impacted holdings and any pending sales programs.
Credit loss on structured securities is determined through a comparison of the security's discounted cash flow to the amortized cost of the security. We, in conjunction with our third-party investment management service providers, make significant assumptions and use scenario-based approaches in our impairment analysis, which are subject to changes as a result of both economic fundamentals and changes in management's estimates in future periods. To the extent that the discounted cash flow is estimated to be lower than the amortized cost of the security, the security is impaired to the discounted cash flow value of all security cash flows, including both coupon and principal repayment, discounted using the forward curve.
Credit losses on corporate securities are determined on an individual security basis. We review the circumstances and conditions associated with credit issuers, including considering credit rating and forecasted operating and financing activities of the issuer. We will make a determination as to whether we believe the issuer is likely to fully meet its contractual principal and interest obligations. To the extent we do not believe that an issuer will meet these obligations, we recognize a credit loss as the difference between the amortized cost and the estimated present value of cash flows expected to be received.
Credit losses on government and government-related securities are determined on an individual security basis. We review the circumstances and conditions associated with government issuers, including credit rating and fundamental views on the government entity under consideration.
We review, on a quarterly basis, the entirety of the equity securities and other investments in our investment portfolio that are in a gross unrealized loss position to assess whether we believe a credit loss, relative to the current cost of the security, exists. In addition, on a quarterly basis, we review any current market developments to identify any new issues that may adversely impact our investment portfolio, and review any impacted holdings and any pending sales programs. Further, we generally impair equities and other investments, if their fair value is 50% or lower than their amortized cost or if the respective security is in a loss position for 11 or more consecutive months.
At December 31, 2017 and 2016, the amount of premiums receivable related to our reinsurance operations amounted to $3.4 billion and $2.5 billion, respectively. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, is not currently due based on the terms of the underlying contracts. Management reviews the premiums receivable balance at least quarterly and provides a provision for amounts deemed to be uncollectible. We recorded a provision for uncollectible premiums receivable related to our reinsurance operations at December 31, 2017 and 2016 of $2.0 million and $1.9 million, respectively.
We had goodwill and other intangible assets of $2.2 billion at December 31, 2017. For further detailed information about the composition and accounting policies surrounding our goodwill and other intangible assets, see Item 8, Note 1(k), "Significant Accounting Policies - Goodwill, Intangibles and Other Long-Lived Assets," and Note 9, "Goodwill and Other Intangible Assets," to the Consolidated Financial Statements included herein.
Intangible assets that are definite lived, including our distribution relationships emanating from the Catlin Acquisition, are tested for recoverability whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Intangible assets that are indefinite lived, including our Lloyd's syndicate capacity emanating from the Catlin Acquisition, are subject to testing for impairment at least annually, or more frequently if potential impairment indicators exist. As with goodwill, both types of intangible asset impairment tests begin with consideration of qualitative factors to determine whether it is more likely than not (i.e. a greater than 50% probability) that the fair value of the intangible asset is greater than its carrying value, and where not, require the performance of a quantitative test to estimate fair value. Such analyses would involve significant judgment, particularly with syndicate capacity, given the need to establish assumptions regarding future revenues and expenses, including the mix of funding sources and associated costs, as well as modeling capital requirements over a very long time horizon.
The following table summarizes our gross premiums written by underwriting business group for the Insurance segment:
2017 vs 2016: Gross premiums written increased by 4.4% and were negatively impacted by foreign exchange rates. When evaluated in local currency, our gross premiums written increased by 4.9%. The unfavorable foreign exchange effect on our gross premiums written was mainly due to a weakening of the British pound against the U.S. dollar.
Global Lines - increase of 0.1% reflects minor variances from the prior year.
North America - increase of 3.6%, due to higher retention and rate improvement in property and construction business lines and an increase in global risk management attributable in part to new business.
2017 vs 2016: The decrease of 0.2% reflects minor variances from the prior year.
The loss and loss expense ratio includes net losses incurred for both the current year and any favorable or adverse prior year development of loss and loss expense reserves held at the beginning of the year. The following table summarizes these components of the loss ratio for the Insurance segment for the years ended December 31, 2017, 2016 and 2015:
2016 vs 2015: The 1.2 percentage point increase in the loss ratio excluding prior year development was primarily as a result of heavier natural catastrophe activity in 2016, partially offset by better attritional loss experience in 2016 as compared to the same period in 2015. Losses net of reinsurance recoveries and reinstatement premiums related to natural catastrophe events
for 2016 were $179.5 million higher than in the same period in 2015. Excluding favorable prior year development and net natural catastrophe losses in both years, the loss ratio for the year ended December 31, 2016 compared to the same period of 2015 improved by 1.1 percentage points to 61.4%.
Operating expense ratio - improvement of 1.5 percentage points due to synergies realized from the Catlin Acquisition, as well as a reduction to variable compensation costs resulting from the natural catastrophe loss impact on our results.
2016 vs 2015: The increase of 1.0 percentage points was due to an increase in the acquisition expense ratio of 1.0 percentage point partially offset by a decrease in the operating expense ratio of 2.0 percentage points as follows:
2016 vs 2015: The decrease compared to the same period of 2015 in net fee income and other expenses was driven by decreased engineering fee income.
2016 vs 2015: Net results from structured insurance products decreased compared to the corresponding period of 2015 mainly due to a reduction of investment income due to declining investment yields.
2017 vs 2016: Gross premiums written increased by 17.8%, primarily driven by new business, share change and reinstatement premiums from significant natural catastrophe activity, partially offset by cancellations. When evaluated in local currency, our gross premiums written increased by 18.8%. When evaluated in local currency and excluding the impact of reinstatement premiums on catastrophe losses activity, our gross premiums written increased by 17.2%.
North America - decrease of 2.2%, mainly attributable to non-renewals within the casualty line of business due to the competitive pricing environment, in addition to prior year premium adjustments within casualty and property facultative lines. These reductions were partially offset by new business in property treaty and casualty treaty lines.
2016 vs 2015: Gross premiums written increased by 74.9%, primarily due to the Catlin Acquisition, as 2015 results only reflect eight months of the combined entities. When evaluated in local currency, our gross premiums written increased by 76.5%.
The following is a summary of the premium movements by region:
Bermuda - increase of 61.4%, primarily due to renewals attributable to the Catlin Acquisition as well as new business with material new inceptions in property treaty and property catastrophe.
LAC - increase of 111.6%, primarily driven by the Catlin Acquisition and related to growth in credit, crop and property treaty lines of business.
2017 vs 2016: The increase of 12.8% largely resulted from the gross written premium increase as outlined above, partially offset by a net increase in premiums ceded due to changes in the timing and mix of purchase of ceded reinsurance.
2016 vs 2015: The 7.6 percentage point increase in the loss ratio excluding prior year development was primarily due to natural catastrophe events. Losses net of reinsurance recoveries and reinstatement premiums related to natural catastrophe events for 2016 were $243.6 million higher than in the same period in 2015. Excluding favorable prior year development and net natural catastrophe losses in both years, the loss ratio for the year ended December 31, 2016 remained steady compared to the same period of 2015 at 52.8%, due to aggregated attritional losses replacing the 2015 large loss from the Tianjin, China port explosion.
2017 vs 2016: The improvement of 0.7 percentage points was due to an improvement in the operating expense ratio of 1.6%, which was partially offset by deterioration in the acquisition expense ratio of 0.9%, as follows:
Acquisition expense ratio - deterioration of 0.9 percentage points predominantly resulting from a change in the product mix mainly as a result of the increase in premium written in Bermuda during the fourth quarter of 2017 noted above, which carries higher acquisition expense ratio.
Operating expense ratio - improvement of 2.2 percentage points, which was a result of synergies realized from the Catlin Acquisition.
As noted in Item 1, "Business - Corporate and Other (Including Run-Off Life Operations)," we have ceded the majority of our life reinsurance business to GCLR through the GreyCastle Life Retro Arrangements. As noted in Item 1, "Business - Corporate and Other (Including Run-Off Life Operations)," we entered into the U.S. Term Life Retro Arrangements, ceding a vast majority of our remaining life reinsurance reserves. At December 31, 2017, gross future policy benefit reserves relating to the Run-Off Life Operations were approximately $3.6 billion, of which we retained $168.3 million, after consideration of all of our future policy benefit reserves recoverable, as noted in Item 8, Note 11, "Future Policy Benefit Reserves," to the Consolidated Financial Statements included herein.
For a further discussion of the GreyCastle Life Retro Arrangements, see Item 8, Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," to the Consolidated Financial Statements included herein.
During the year ended December 31, 2015, we entered into the U.S. Term Life Retro Arrangements, which ceded the vast majority of our remaining life reinsurance business. We recorded a net loss of approximately $35.0 million associated with the transaction. See Item 8, Note 11, "Future Policy Benefit Reserves" to the Consolidated Financial Statements included herein for further information.
For a summary of realized and unrealized gains and losses on all derivative instruments, see Item 8, Note 7, "Derivative Instruments," to the Consolidated Financial Statements included herein.
Net income from investment affiliates includes earnings from our investments in closed-end investment funds and partnerships and similar vehicles that are accounted for under the equity method, as well as certain co-investment holdings sourced for us by the managers of affiliate funds also accounted for under the equity method.
2017 vs 2016: Performance for the year ended December 31, 2017 was very strong as compared to the same period in 2016 and was driven principally by the hedge fund affiliate results. Strong positive contributions came from funds pursuing equity long/short, quantitative equity market neutral, macro and fixed income strategies. Additionally, our position sizing was a positive contributor to results. Also included in the results was the $32.0 million benefit recognized through earnings as a fund moved from "Other investments" to "Investment in affiliates" due to our increased ownership stake in the normal course of business. The Company's private investments also produced solid performance for the year ended December 31, 2017, outperforming prior year results for the same period, driven mainly by returns in financial services sector funds, turnaround funds and several related co-investments. The results for private credit funds lagged slightly behind the prior year.
2016 vs 2015: Performance for 2016, despite a 3.5% decrease from the prior year, was strong, lagging slightly behind strong results from 2015. Overall, hedge fund returns were weaker in 2016 as compared to 2015, as elevated volatility during most of the year challenged hedge fund affiliate results. In particular, funds pursuing quantitative equity strategies and market directional strategies, including equity long/short and macro, weighed on results for the year. This decrease in performance during 2016 was offset by a one time recognition of income from the reclassification of two of our hedge funds from "Other investments" to "Investment in affiliates" upon increasing our ownership stakes. The Company's private equity and private credit funds produced strong performance for the year ended December 31, 2016, in line with the prior year results.
2017 vs 2016: Net realized gains on investments of $122.2 million in the year ended December 31, 2017 included net realized gains of $135.6 million, which resulted primarily from sales of equities, corporate fixed maturities and other investments. These amounts were offset by losses of approximately $13.3 million related to OTTI charges on certain of our
2016 vs 2015: For the years ended December 31, 2016 and 2015, net realized gains on investments of $112.7 million and $20.0 million, respectively, included net realized gains of $191.2 million and $103.0 million, respectively, which resulted primarily from sales of equities and fixed maturities. These amounts were partially offset by realized losses of approximately $78.6 million and $83.0 million, respectively, related to the write-down of certain investments. For further discussion, see Item 8, Note 4, "Investments," to the Consolidated Financial Statements included herein.
2017 vs 2016: Net realized and unrealized losses on derivative instruments of $41.7 million in the year ended December 31, 2017 resulted mainly due to unrealized losses on an embedded derivative contained within funds withheld life reinsurance contracts as well as unrealized losses on an embedded derivative within P&C ceded reinsurance contracts written on a funds withheld basis. We also incurred net losses from our investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments and other hedging activities. In addition, we also reported net losses from non-investment hedging activities. For a further discussion, see Item 8, Note 7, "Derivative Instruments," to the Consolidated Financial Statements included herein.
The following table sets forth our other revenues and expenses for the years ended December 31, 2017, 2016 and 2015:
The following table sets forth the net income (loss) from operating affiliates for the years ended December 31, 2017, 2016 and 2015:
2017 vs 2016: The increase of 28.2% was primarily due to the gain on the sale of one of our investment manager affiliates, partially offset by lower incentive fees. Prior year results also benefited from a gain on the sale of one of our service provider affiliates but to a lesser degree.
2016 vs 2015: The results for 2016 reflect an increase in the amount of incentive fees generated by our larger investment manager affiliates relative to the prior year, as well as a gain from the sale of the Company's interest in one of our service provider stakes in the current year, offset by a partial write-down taken on the carrying value of one of our investment manager affiliates.
2016 vs 2015: In 2016, foreign exchange gains of $9.6 million were principally a result of the strengthening of the U.S. dollar against our British pound denominated liabilities held in U.S. dollar denominated units. These gains were partially offset by the weakening of the U.S. dollar against the Brazilian Real on net monetary liabilities in that currency and by the effect of the U.S. dollar strengthening against the Singapore dollar on net monetary assets in that currency.
2017 vs 2016: The decrease of 39.8% was primarily due to lower integration expenses related to the Catlin Acquisition and synergies realized during the past year, reflecting our continuing focus on operating efficiency and leveraging our underwriting platform, as well as a reduction to variable compensation costs resulting from the natural catastrophe loss impact on our results.
The Company is a party to the GreyCastle Life Retro Arrangements, as described in Item 8, Note 1(c), "Significant Accounting Policies - Investments - Investments Related to Life Retrocession Arrangements written on a Funds Withheld Basis," Note 1(e), "Significant Accounting Policies - Reinsurance," and Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," to the Consolidated Financial Statements included herein. The embedded derivative is recorded at fair value with changes in fair value recognized in earnings through "Net realized and unrealized gains (losses) on life retrocession embedded derivative and derivative instruments - Life Funds Withheld Assets." For a further discussion, see
2017 vs 2016: The decrease of 2.9% was the result of lower interest expense attributable to funds withheld balances, with an offsetting impact due to the issuance of debt during the year.
2016 vs 2015: The tax expense of $42.1 million recognized in 2016 was primarily driven by the geographical distribution of profits and losses between taxable and non-taxable jurisdictions. The 2016 tax expense differed significantly from the 2015 tax benefit of $19.2 million, as the 2015 tax benefit resulted primarily from the $59.6 million valuation allowance release related to the restructuring of the U.S. operations.
Our investment strategy is based on a Strategic Asset Allocation process that establishes a strategic benchmark, which is a portfolio asset allocation target that is constructed to maximize enterprise value subject to business constraints and the risk tolerance of the Company's management, and is approved by the RFC. The investment team actively seeks to exceed the total return of the strategic benchmark and meet budgeted investment earnings, while maintaining sufficient liquidity to ensure payment of claims, operating expenses and other obligations even during stressed scenarios. Active or tactical deviations from the benchmark are controlled by a comprehensive framework of investment decision authorities ("Authorities Framework"), which ensures that the risk profile of our investment portfolio is consistent with management's risk tolerance.
At December 31, 2017 and 2016, total investments and cash and cash equivalents, including accrued investment income and net receivable/(payable) for investments sold/(purchased), but excluding Life Funds Withheld Assets, were approximately $37.1 billion and $36.6 billion, respectively. The following table summarizes the composition of our invested assets, excluding Life Funds Withheld Assets, at December 31, 2017 and 2016:
The credit rating for each asset reflected above was principally determined based on the weighted average rating of the individual securities from Standard & Poor's, Moody's Investors Service and Fitch Ratings (when available). U.S. Agency debt and related mortgage-backed securities, whether with implicit or explicit government support, reflect the credit quality rating of the U.S. government for the purpose of these calculations. For U.S. Government and government agencies, the average rating remains AAA as only one of the three major rating agencies downgraded the U.S. from AAA to AA+ in 2011.
We had gross unrealized losses totaling $199.3 million on 2,950 securities out of a total of 7,822 held at December 31, 2017 in our AFS portfolio (excluding Life Funds Withheld Assets and Other Investments) that can be attributed to the following significant drivers:
gross unrealized losses of $57.3 million related to Corporate holdings. Securities in a gross unrealized loss position had a fair value of $3.5 billion at December 31, 2017.
The following is the maturity profile of the AFS fixed income securities that were in a continual gross unrealized loss position at December 31, 2017:
As developed markets emerged from the global recession, several key nations within the E.U. - particularly Greece, Italy, Ireland, Portugal and Spain (the "European Periphery Nations") - have carried particularly high levels of debt and have been slower to return to positive economic growth due to austerity measures implemented to lower such countries' debt levels, and a general lack of competitiveness. The ECB has taken various measures and has asserted its willingness to take any measures deemed necessary to protect these European Periphery Nations' ability to continue to fund their debt. As a result, we believe market risks associated with the European Sovereign Debt have been greatly reduced.
As described in Item 8, Note 1(b), "Significant Accounting Policies - Fair Value Measurements," and Item 8, Note 8, "Fair Value Measurements," to the Consolidated Financial Statements included herein, we have provided required disclosures by Level 1, 2 and 3 within the fair value hierarchy of the Company's assets and liabilities that are carried at fair value, including valuation methodologies.
Excluded from Other investments balances are $198.2 million measured using Net Asset Value. Based on new accounting guidance, these investments are excluded from the fair value hierarchy table. In addition, the Other investment balance excludes a payment obligation which totaled $173.0 million at December 31, 2017 and was carried at amortized cost. For further information, see Item 8, Note 6, "Other Investments," to the Consolidated Financial Statements included herein.
We establish reserves to provide for the ultimate settlement of claims and the general expenses associated with administering the claims adjustment process, including losses which have been incurred but not reported. These reserves are calculated using actuarial and other reserving techniques to project the estimated ultimate net liability for losses and loss expenses. Our reserving practices and the establishment of any particular reserve reflect our judgment concerning sound financial practice and do not represent any admission of liability with respect to any claims made against us.
Gross unpaid losses and loss expenses totaled $29.7 billion and $25.9 billion at December 31, 2017 and 2016, respectively. The table below represents a reconciliation of our P&C unpaid losses and loss expenses for the year ended December 31, 2017:
While we regularly review the adequacy of established reserves for unpaid losses and loss expenses, 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. For further discussion, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates - 1) Unpaid Loss and Loss Expenses and Unpaid Loss and Loss Expenses Recoverable," and Item 8, Note 10, "Losses and Loss Expenses," to the Consolidated Financial Statements included herein.
Liquidity is a measure of our ability to generate sufficient cash flows to meet the short and long-term cash requirements of our business operations. As a global insurance and reinsurance company, one of our principal responsibilities to clients is to ensure that we have ready access to funds with which to settle large or multiple unforeseen claims. We would generally expect that positive cash flow from operations (underwriting activities and investment income) will be sufficient to cover cash outflows under most future loss scenarios. However, there is a possibility that unforeseen demands could be placed on us due to extraordinary events and, as such, our liquidity needs may change. Such events include, among other things: several significant catastrophes occurring in a relatively short period of time resulting in material incurred losses; rating agency downgrades of our core insurance and reinsurance subsidiaries that would require posting of collateral in connection with our letter of credit and revolving credit facilities; and the return of unearned premiums and/or the settlement of derivative transactions and large scale uncollectible reinsurance recoverables on paid losses (as a result of coverage disputes, reinsurers' credit problems or decreases in the value of collateral supporting reinsurance recoverables). Any one or a combination of such events may cause a liquidity strain for us. In addition, a liquidity strain could also occur when there is illiquidity in financial markets, such as that which was experienced in 2008. Investments that may be used to meet liquidity needs in the event of a liquidity strain may not be liquid due to inactive markets, or may have to be sold at a significant loss as a result of depressed prices. Because each subsidiary focuses on a more limited number of specific product lines than is collectively available from the consolidated group of companies, the mix of business tends to be less diverse at the subsidiary level. As a result, the probability of a liquidity strain,
XL Group's future cash flows largely depend on the availability of dividends or other permissible payments from subsidiaries to make principal and interest payments on debt, to pay operating expenses and common shareholder dividends, to make capital investments in subsidiaries and to pay other obligations that may arise from time to time. The ability of our subsidiaries to pay dividends to us or return capital from shareholders' equity is limited by applicable laws and regulations of the various jurisdictions in which we operate, certain additional required regulatory approvals and financial covenants contained in our letter of credit and revolving credit facilities. The payment of dividends by our principal operating subsidiaries is regulated under the laws of various jurisdictions including Bermuda, the U.K., Ireland and Switzerland, certain insurance statutes of various U.S. states in which principal operating subsidiaries are licensed to transact business, the other jurisdictions where we have regulated subsidiaries and regulations of the Society of Lloyd's. See Item 8, Note 24, "Statutory Financial Data," to the Consolidated Financial Statements included herein for further discussion and details regarding the dividend capacity of our major operating subsidiaries. See also Item 1A, "Risk Factors - Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends, make payments on our debt securities and make other payments," included herein. No assurance can be given that our subsidiaries will pay dividends in the future to XL Group and XLIT.
Under Bermuda law, XL Group is required to pay cash dividends from contributed surplus. As of December 31, 2017, XL Group had $7.8 billion in contributed surplus.
At December 31, 2017, XL Group and XLIT held cash and investments, net of liabilities associated with cash sweeping arrangements, of $4.0 million and $0.7 billion, respectively, compared to $1.0 million and $0.7 billion, respectively, at December 31, 2016.
All of our outstanding debt as of December 31, 2017 was issued by XLIT. The ability of XLIT, like that of XL Group, to obtain funds from its subsidiaries to satisfy any of its debts, including obligations under guarantees, is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which we operate, including, among others, Bermuda, the U.S., Ireland, Switzerland and the U.K. For details of the required statutory capital and surplus for our principal operating subsidiaries, see Item 8, Note 24, "Statutory Financial Data," to the Consolidated Financial Statements included herein. See also the Consolidated Statements of Cash Flows in Item 8, Financial Statements, included herein.
During the year ended December 31, 2017, net cash flows provided by operating activities were $33.3 million compared to net cash flows provided by operating activities of $943.9 million for the same period in 2016, a decrease of $910.6 million. The decrease was a result of increased loss payments due to the significant natural catastrophe activity in 2017.
Net cash provided by investing activities was $662.7 million in the year ended December 31, 2017, compared to $737.8 million for the same period in 2016, a decrease of $75.0 million. The decrease is a result of trading activity in the ordinary course of business, however had a higher turnover year over year within the investment portfolio from active sector rotation and portfolio management activities.
Cash flows related to financing activities include common and preference share related transactions, the payment of dividends, the issuance or repayment of XLIT's preference ordinary shares, the issuance or repayment of debt and deposit liability transactions. During the year ended December 31, 2017, net cash flows used in financing activities were $743.8 million compared to net cash used in financing activities of $1.5 billion for the same period in 2016, a decrease of $709.4 million. Financing cash flows were impacted by an decrease in share buybacks of $479.4 million compared to 2016, as well as a debt issuance of $558.3 million in 2017, partially offset by the repurchase of preference shares of $411.5 million. For further information on the drivers of our financing activity and capital management, see "Other Key Focuses of Management - Capital Management," Item 8, Note 14, "Notes Payable and Debt and Financing Arrangements" to the Consolidated Financial Statements and Item 8, Note 19, "Share Capital" to the Consolidated Financial Statements included herein.
At December 31, 2017 and 2016, we had total shareholders' equity of $11.5 billion and $13.0 billion, respectively. In addition to common share capital, we depend on external sources of financing to support our underwriting activities in the form of:
The following risks are associated with our requirement to renew or obtain new credit facilities:
The following table summarizes the components of our current capital resources:
The following table reconciles the opening and closing common share capital positions as follows:
For details regarding the outstanding issues of unsecured notes at December 31, 2017 and for further information on our debt see Item 8, Note 14(a), "Notes Payable and Debt and Financing Arrangements - Notes Payable and Debt," to the Consolidated Financial Statements included herein.
The following table presents the Company's ten unsecured LOC facilities and revolving credit facilities at December 31, 2017:
We have the option to increase the size of the facilities under the Syndicated Facilities by an additional $500 million across both such facilities.
As of December 31, 2017, the portion of the total LOC facilities allowable to be utilized for revolving loans was $750.0 million. However, $2 million of this allowable portion was utilized to issue letters of credit, leaving $748.0 million available either to issue additional letters of credit or to support other operating or financing needs under these particular facilities.
See Item 8, Note 14(b), "Notes Payable and Debt and Financing Arrangements - Letter of Credit Facilities and Other Sources of Collateral," to the Consolidated Financial Statements included herein for further information.
Consolidated Net Worth means total shareholders' equity (a) minus Exempt indebtedness (and the assets relating thereto) in the event such Exempt Indebtedness is consolidated on our Consolidated Balance Sheets in accordance with GAAP, (b) plus the amounts recorded on our Consolidated Balance Sheets in respect of Hybrid Capital and (c) without giving effect to the impact (positive or negative) of accumulated other comprehensive income/(loss) reflected on our Consolidated Balance Sheets.
The following describes certain terms of the debt instruments referred to above. Our material credit agreements and indentures governing XLIT's notes have been filed with the SEC and should be referred to for an assessment of our complete contractual obligations.
The majority of our bank facilities, indentures and other documents relating to our outstanding indebtedness, including the credit facilities discussed above (collectively, the "Debt Documents"), contain cross acceleration or cross default provisions to each other and the Debt Documents contain affirmative covenants. These covenants provide for, among other things, a maximum ratio of total consolidated debt to the sum of total consolidated debt plus consolidated net worth. In addition, the Debt Documents contain other customary affirmative and negative covenants as well as certain customary events of default. Generally each of the Debt Documents provides for an event of default in the event of certain events involving bankruptcy, insolvency or reorganization of the Company, and the majority of our bank facilities provide for an event of default in the event of a change of control of the Company subject to certain exceptions.
Given that in general the Debt Documents contain cross acceleration or cross default provisions, this may result in all holders declaring such debt due and payable and an acceleration of all debt due under those documents. If this were to occur, we may not have funds sufficient at that time to repay any or all of such indebtedness.
Consolidated Statements of Comprehensive Income for the years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Shareholders' Equity for the years ended December 31, 2017, 2016 and 2015
In connection with the Redomestication, on August 3, 2016, XL-Ireland distributed the ordinary shares of XLIT, to XL Group (the "Distribution"), which was recorded on the share register of XLIT on August 4, 2016. As a result of the Distribution, XLIT is now a direct, wholly-owned subsidiary of XL Group. It is anticipated that XL-Ireland will be liquidated (via a solvent members' voluntary liquidation that was initiated on August 2, 2016) by the end of 2018.
While management believes that the amounts included in the consolidated financial statements reflect the Company's best estimates and assumptions, actual results could differ materially from these estimates.
Fair value measurements accounting guidance also establishes a fair value hierarchy that prioritizes the inputs to the respective valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). An asset or liability's classification within the fair value hierarchy is based on the lowest level of significant input to its valuation. The three levels of the fair value hierarchy are described further below:
It is common industry practice to utilize pricing services as a source for determining the fair values of investments where the pricing services are able to obtain sufficient market-corroborating information to allow them to produce a valuation at a reporting date. In addition, in the majority of cases, although a value may be obtained from a particular pricing service for a security or class of similar securities, these values are corroborated against values provided by other pricing services. The pricing services use market approaches to valuations using primarily Level 2 inputs in the vast majority of valuations, or some form of discounted cash flow analysis, to obtain investment values for a small percentage of fixed income securities for which they provide a price. Standard inputs to the valuations provided by the pricing services listed in approximate order of priority for use when available include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. The pricing services may prioritize inputs differently on any given day for any security, and not all inputs listed are available for use in the evaluation process on any given day for each security evaluation; however, the pricing services also monitor market indicators, customer feedback through a price challenge process and industry and economic events. Information of this nature is a trigger to acquire further corroborating market data. When these inputs are not available, they identify "buckets" of similar securities (allocated by asset class types, sectors, sub-sectors, contractual cash flows/structure, and credit rating characteristics) and apply some form of matrix or other modeled pricing to determine an appropriate security value that represents their best estimate as to what a buyer in the marketplace would pay for a security in a current sale. Prices provided by independent pricing services and independent broker quotes can vary widely even for the same security. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts. While the Company receives values for the majority of the investment securities it holds from pricing services, it is ultimately management's responsibility to determine whether the values received and recorded in the financial statements are representative of appropriate fair value measurements.
Broker/dealer quotations are used to value fixed maturities where prices are unavailable from pricing services due to factors specific to the security such as limited liquidity, lack of current transactions, or trades only taking place in privately negotiated transactions. These are considered Level 3 valuations, as significant inputs utilized by brokers may be difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not available to support a Level 2 classification.
Equity securities include investments in open-end mutual funds, exchange-traded funds and shares of publicly traded companies. The fair value of equity securities is based upon quoted market values (Level 1), or monthly net asset value statements provided by the investment managers upon which subscriptions and redemptions can be executed (Level 2).
The Company generally records its hedge fund and private investment affiliates on a one-month and three-month lag, respectively, and its operating affiliates on a three-month lag. Significant influence is considered on a case-by-case basis. Investments in affiliates are not subject to fair value measurement guidance, as they are not considered to be fair value measured investments under GAAP. However, impairments associated with investments in affiliates that are deemed to be other-than-temporary are calculated in accordance with fair value measurement guidance and appropriate disclosures included within the financial statements during the period the losses are recorded.
Level 2. Investments for which fair value is estimated using net asset value per share as a practical expedient are excluded from the fair value hierarchy. Private equity investments are classified as Level 3. The net unrealized gain or loss on investments, net of tax, is included in "Accumulated other comprehensive income (loss)." Any unrealized loss in value considered by management to be other-than-temporary is charged to income in the period in which such determination is made.
Overseas deposits include investments in private funds related to Lloyd's syndicates in which the underlying instruments are primarily fixed maturities. The funds themselves do not trade on an exchange and therefore are not included within available for sale securities. Also included in overseas deposits are restricted balances held by Lloyd's syndicates for solvency purposes, which are primarily invested in cash and cash equivalents. Given the restricted nature of these balances, they are included in other investments on the Consolidated Balance Sheets. Each of these investment types is considered a Level 2 valuation.
Acquisition costs, which vary with and are directly related to the acquisition of policies, consist primarily of: a) commissions paid to brokers and cedants, and b) premium-related taxes, are deferred and amortized over the period during which the premiums are earned. Acquisition costs are shown net of contractual commissions earned on reinsurance ceded. Future earned premiums, the anticipated losses and other costs (and in the case of a premium deficiency, investment income) related to those premiums, are also considered in determining the level of acquisition costs to be deferred.
In the normal course of business, the Company seeks to reduce the potential amount of loss arising from claims events by reinsuring certain levels of risk assumed in various areas of exposure with other insurers or reinsurers. Reinsurance premiums ceded are expensed (and any commissions recorded thereon are earned) on a monthly pro-rata basis over the period the reinsurance coverage is provided. Ceded unearned reinsurance premiums represent the portion of premiums ceded applicable to the unexpired term of policies in force. Reinstatement premiums ceded are recognized at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are fully earned when
The Company enters into ceded reinsurance agreements with other companies in the normal course of business. All premium and loss-related balances related to reinsurance agreements are reported on a gross basis within our Consolidated Balance Sheets, with the exception of the GreyCastle Life Retro Arrangements, which were written on a funds withheld basis. The future policy benefit reserves recoverable related to these retrocession arrangements are netted against the funds withheld liability owing to the counterparty on the Consolidated Balance Sheets due to the contractual right of offset.
The Company's process for identifying declines in the fair value of investments that are other-than-temporary involves consideration of several factors. The primary factors include (i) an analysis of the liquidity, business prospects and financial condition of the issuer, including consideration of credit ratings, (ii) the significance of the decline, (iii) an analysis of the collateral structure and other credit support, as applicable, of the securities in question, and (iv) for debt securities, whether the Company intends to sell such securities. In addition, the authoritative guidance requires that OTTI for certain asset-backed and mortgage-backed securities be recognized if the fair value of the security is less than its discounted cash flow value and there has been a decrease in the present value of the expected cash flows since the last reporting period. Where the Company's analysis of the above factors results in the Company's conclusion that declines in fair values are other-than-temporary, the cost of the security is written down to discounted cash flow, and a portion of the previously unrealized loss is therefore realized in the period such determination is made.
In instances in which the Company determines that a credit loss exists but the Company does not intend to sell the security, and it is not more likely than not that the Company will be required to sell the security before the anticipated recovery of its remaining amortized cost basis, the OTTI is separated into (1) the amount of the total impairment related to the credit loss and (2) the amount of the total impairment related to all other factors (i.e. the noncredit portion). The amount of the total OTTI related to the credit loss is recognized in earnings and the amount of the total OTTI related to all other factors is recognized in accumulated other comprehensive loss. The total OTTI is presented in the Consolidated Statements of Income with an offset for the amount of the total OTTI that is recognized in accumulated other comprehensive income (loss). Absent the intent or requirement to sell a security, if a credit loss does not exist, any impairment is considered to be temporary.
subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company's portfolio as available for sale.
Derivative contracts can be exchange-traded or over-the-counter ("OTC"). Exchange-traded derivatives (futures and options) typically fall within Level 1 of the fair value hierarchy, depending on whether they are deemed to be actively traded or not. OTC derivatives are valued using market transactions and other market evidence whenever possible, including market-based inputs to models, model calibration to market clearing transactions, broker or dealer quotations or alternative pricing sources where an understanding of the inputs utilized in arriving at the valuations is obtained. Where models are used, the selection of a particular model to value an OTC derivative depends upon the contractual terms and specific risks inherent in the instrument as well as the availability of pricing information in the market. The Company generally uses similar models to value similar instruments. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. For OTC derivatives that trade in liquid markets, such as generic forwards, interest rate swaps and options, model inputs can generally be verified and model selection does not involve significant management judgment. Such instruments comprise the majority of derivatives held by the Company and are typically classified within Level 2 of the fair value hierarchy.
Certain OTC derivatives trade in less liquid markets with limited pricing information, or required model inputs that are not directly market corroborated, which causes the determination of fair value for these derivatives to be inherently more subjective. Accordingly, such derivatives are classified within Level 3 of the fair value hierarchy. The valuations of less standard or less liquid OTC derivatives are typically based on Level 1 and/or Level 2 inputs that can be observed in the market, as well as unobservable Level 3 inputs. Level 1 and Level 2 inputs are regularly updated to reflect observable market changes. Level 3 inputs are changed only when corroborated by evidence such as similar market transactions, pricing services and/or broker or dealer quotations. The Company conducts its non-hedging derivatives activities in three main areas: investment related derivatives, credit derivatives and other non-investment-related derivatives.
"net realized and unrealized gains and losses on derivative instruments"), with any differences between the net change in fair value of the derivative and the hedged item representing the hedge ineffectiveness. Periodic derivative net coupon settlements are recorded in net investment income, with the exception of hedges of Company-issued debt, which are recorded in interest expense. The Company may designate fair value hedging relationships where interest rate swaps are used to hedge the changes in the fair value of certain fixed rate liabilities and fixed maturity securities due to changes in the designated benchmark interest rate.
Changes in the fair value of a derivative that is designated and qualifies as a cash flow hedge are recorded in accumulated other comprehensive income ("AOCI") and are reclassified into earnings when the variability of the cash flow of the hedged item impacts earnings. Gains and losses on derivative contracts that are reclassified from AOCI to current period earnings are included in the line item in the consolidated statements of operations in which the cash flows of the hedged item are recorded. Any hedge ineffectiveness is recorded immediately in current period earnings as "net realized and unrealized gains and losses on derivative instruments." Periodic derivative net coupon settlements are recorded in net investment income. The Company may designate cash flow hedging relationships where interest rate swaps are used to mitigate interest rate risk associated with anticipated issuances of debt or other forecasted transactions.
Restricted cash represents cash and cash equivalents that the Company is a) holding for the benefit of a third party and is legally or contractually restricted as to withdrawal or usage for general corporate purposes; and b) not replaceable by another type of asset other than cash or cash equivalents, under the terms of the Company's contractual arrangements with such third parties. Restricted cash includes cash and cash equivalents held pursuant to the terms of the Company's contractual obligations relating to the GreyCastle Life Retro Arrangements described in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation."
Assets and liabilities of foreign operations whose functional currency is not the U.S. dollar are then translated into the Company's U.S. reporting currency at prevailing balance sheet-date exchange rates, while revenue and expenses of such foreign operations are translated into the Company's U.S. reporting currency at monthly average exchange rates during the year. The net effect of these translation adjustments, as well as any gains or losses on intercompany balances for which settlement is not planned or anticipated in the foreseeable future, net of applicable deferred income taxes, are included in the Consolidated Balance Sheets as part of "Accumulated other comprehensive income."
The Company has recorded goodwill in connection with various acquisitions in prior years. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired. In accordance with GAAP, the Company tests goodwill for potential impairment annually as of June 30, and between annual tests if an event occurs or circumstances change that may indicate that the potential exists for the fair value of a reporting unit to be reduced to a level below its carrying amount. The Company tests for impairment at the reporting unit level in accordance with the authoritative guidance on intangibles and goodwill. The Company has organized its goodwill into two reporting units, reflecting its two segments.
All of the Company's depreciable or amortizable intangible and other long-lived assets such as trade names, distribution networks, premises, equipment, agency relationships, and acquired or internally-developed software, are carried at net book value, and are depreciated or amortized on a straight-line basis over their estimated useful lives. The amortization periods approximate the period over which the Company expects to generate future net cash inflows from the use of these assets. All of these assets are subject to impairment testing in accordance with authoritative guidance for the impairment or disposal of long-lived assets when events or conditions indicate that the carrying value of an asset may not be fully recoverable from future cash flows. See Note 9, "Goodwill and Other Intangible Assets" for further information.
A VIE must be consolidated by its primary beneficiary, which is the variable interest holder that is determined to have the controlling financial interest in the entity. This is the entity that has both: a) the power to direct the VIE's activities that most significantly impact its economic performance, and b) the obligation to absorb losses or receive benefits of the VIE that could potentially be significant to it. Refer to Note 16, "Variable Interest Entities," for further discussion of the Company's interests in VIEs.
Unpaid losses and loss expenses include reserves for reported unpaid losses and loss expenses and for losses incurred but not reported. The reserve for reported unpaid losses and loss expenses for the Company's property and casualty ("P&C") operations is established by management based on claims reported from insureds or amounts reported from ceding companies, and represent the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company.
Certain workers' compensation and certain U.K. bodily injury liabilities are considered fixed and determinable and are discounted.
Management believes that the reserves for unpaid losses and loss expenses are sufficient to cover losses that fall within coverages assumed by the Company. However, there can be no assurance that losses will not exceed the Company's total reserves. The methodology of estimating loss reserves is periodically reviewed to ensure that the assumptions made continue to be appropriate and any adjustments resulting from such reviews are reflected in income in the year in which the adjustments are made.
At December 31, 2017, the Company had several stock-based performance incentive programs, which are described more fully in Note 19, "Share Capital." Stock-based compensation issued under these plans generally has a life of not longer than ten years and vests as set forth at the time of grant. Awards generally vest annually over three or four years from the date of grant. The Company recognizes compensation costs for stock-based awards on a straight-line basis over the requisite service period (usually the vesting period) for each award.
In March 2016, as part of its simplification initiative, the Financial Accounting Standards Board (the "FASB") issued an accounting standards update concerning the accounting for several aspects of employee share-based payment awards including: income tax consequences, classification of awards as either equity or liabilities, classification of items in the statement of cash flows, and certain expedients that entities can now elect regarding estimates and assumptions in this area. The guidance was effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The Company adopted this guidance during the first quarter of 2017 in accordance with the following:
The tax effects of exercised or vested awards should be treated as discrete items in the reporting period in which they occur. Adoption of this amendment had no impact on the Company's financial position or results of operations.
Where an employer withholds shares for employee tax-withholding purposes, the resulting employee taxes paid should be classified as a financing activity as opposed to an operating activity in the statement of cash flows. This amendment was applied retrospectively. The withholding taxes are now included within the financing section of the statement of cash flows. The statement of cash flows for the years ended December 31, 2016 and 2015 has been re-presented by $28.6 million and $28.9 million, respectively, to conform to the current year presentation.
ASU 2016-17 Interests Held through Related Parties That Are under Common Control
In January 2017, the FASB issued an accounting standards update concerning impairment testing of goodwill. The main provision of this guidance removes the existing "Step 2" analysis required under previous GAAP. The previous GAAP required an entity to perform procedures to determine the fair value at the impairment testing date of its assets and liabilities (including unrecognized assets and liabilities) following the procedures that would be required in determining the fair value of assets acquired and liabilities assumed in a business combination. Instead, under the revised guidance, an entity's annual goodwill impairment review should include a "quantitative impairment test" in which it should compare the fair value of a reporting unit with its carrying amount. If the carrying amount exceeds the fair value, then the entity should record an impairment charge for this difference, limited to the total goodwill allocated to the reporting unit (an entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary). The update should be applied on a prospective basis. This guidance is effective for goodwill impairment testing performed in fiscal years beginning after December 15, 2019 bur early adoption was permitted for goodwill impairment tests performed on testing dates after January 1, 2017. The Company elected to early adopt this guidance during the first quarter of 2017. While the guidance changed the Company's goodwill impairment testing procedures, there was no impact on the Company's financial position, results of operations or cash flows.
In March 2017, the FASB issued an accounting standards update concerning the accounting for premiums on purchased callable debt securities. The premium is the amount by which the amortized cost basis of the security exceeds the amount repayable by the issuer. For callable debt securities, this ASU requires that the premium be amortized to the earliest call date. Under previous GAAP, premiums were typically amortized to the maturity date of a security, except where an entity held a large number of similar loans and considered estimates of future principal repayments. The amendments do not require an accounting change for securities held at a discount. The update should be applied on a modified retrospective basis. The guidance is effective for fiscal years beginning after December 15, 2019 and interim periods within years beginning after December 15, 2020 but early adoption was permitted. The Company elected to early adopt this guidance during the first quarter of 2017. There was no impact on the Company's financial position, results of operations or cash flows.
In January 2016, the FASB issued an accounting standards update concerning the accounting for financial instruments. The guidance retains the basic existing framework for accounting for financial instruments under GAAP, while achieving limited convergence with IFRS in this area. The guidance: (1) requires equity investments (except consolidated entities and those accounted for under the equity method of accounting) to be measured at fair value with changes in fair value recognized in net income; (2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) eliminates the requirement to disclose the fair value of financial instruments measured at amortized cost for non-public business entities; (4) eliminates the requirement to disclose the method(s) and significant assumptions used to estimate the fair value of financial instruments measured at amortized cost on the balance sheet; (5) requires public business entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes; (6) requires an entity to present separately in other comprehensive income the portion of the total change in the fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option for financial statements; (7) requires separate presentation of financial assets and financial liabilities by measurement category and form of asset in the financial statements; and (8) clarifies that an entity should evaluate the need for a valuation allowance on a deferred tax asset related to AFS securities in combination with the entity's other deferred tax assets. The guidance will be effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. Adoption should be applied by means of a cumulative effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption, except the amendments related to impairment of equity securities without readily determinable fair values. The Company will adopt this guidance as of January 1, 2018. As of that date, accumulated unrealized gains and losses relating to investments in equity securities and certain of our other investments, net of tax, which are included in accumulated other comprehensive income, will be classified to retained earnings. At December 31, 2017 the amount subject to reclassification is a net unrealized gain of $235.2 million, less deferred tax of $12.1 million. Adoption of this update will also have an effect on results of operations going forward, as mark to market movements on equity securities will prospectively impact net income; however, it will not have a material impact on the Company's cash flows.
In February 2016, the FASB issued an accounting standards update concerning the accounting for leases. The most significant change to existing GAAP created by this standard will be the lessee recognition of lease assets and lease liabilities for those leases classified as operating. The core principle of this guidance stipulates that a lessee should recognize in the statement of financial position, initially measured at the present value of the lease payments, both a liability for contractual payments due under the lease, and an asset representing its right to use the underlying leased asset for the lease term ("right-of-use asset"). For financing leases, interest on the lease liability should be recognized separately from the amortization of the right-of-use asset in the statement of comprehensive income. Additionally, as regards the presentation of financing lease activities within the statement of cash flows, repayments of the principal portion of the lease liability should be classified within financing activities, while payments of interest on the lease liability should be classified within operating activities. For operating leases, a single net lease cost should be recognized over the lease term, generally on a straight-line basis, and all cash payments related to the lease should be classified within operating activities in the statement of cash flows. For leases with a term of 12 months or less, a lessee is permitted to make an accounting policy election by class of underlying asset not to recognize lease assets and lease liabilities, and therefore recognize lease expense for such leases on a straight-line basis over the lease term. The guidance will be effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted. In transition, lessees and lessors are required to recognize and measure leases at the beginning of the earliest period presented using a modified retrospective approach, which includes a number of optional practical expedients that entities may elect to apply. An entity that elects to apply the practical expedients will substantively
In June 2016, the FASB issued an accounting standards update concerning the measurement of credit losses on financial instruments. The amendments in this update affect the measurement of various financial assets, including loans, debt securities, trade receivables, reinsurance receivables and net investments in leases. For assets measured at amortized cost, the amendments in this update require presentation at the net amount expected to be collected. This results in an allowance for all expected credit losses over an asset’s entire life, with no threshold for recognition. This allowance should be maintained in a valuation account that is deducted from the amortized cost of the asset to result in the net amount for presentation purposes. Credit loss allowances for newly created financial assets and subsequent movements in these allowances will be recognized in the income statement, except for the initial credit losses on assets that are purchased in an already credit-impaired state, which will be added to the purchase price of such assets. For AFS debt securities, credit losses should also be recorded through an allowance. The allowance for credit losses is restricted to the difference between the fair value and amortized cost of the relevant asset. The guidance will be effective for fiscal years, and interim periods within those fiscal years beginning after December 15, 2019. Early adoption is permitted for fiscal years, and interim periods within those fiscal years beginning after December 15, 2018. The updates should be adopted in a modified-retrospective approach, by means of a cumulative-effect adjustment to retained earnings at the beginning of the first reporting period in which the guidance is effective. For securities with an existing other-than-temporary impairment or securities previously acquired with deteriorated quality the relevant provisions should be adopted prospectively. The Company is currently evaluating this guidance and expects that it will have an impact on the Company’s financial position and results of operations, but will not have a material impact on the Company’s cash flows.
In October 2016, the FASB issued an accounting standards update concerning the tax effects of intra-entity asset transfers within a group. The new guidance requires an entity to reflect the income tax consequences of an intra-entity transfer of an asset other than inventory when that transfer occurs. This is a departure from current GAAP, which prohibits recognition of tax on such transfers until the asset has been sold to an external party or otherwise realized. The amendments are effective for annual reporting periods beginning after December 15, 2017, and interim periods within those fiscal years. The amendments should be applied on a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. The Company will adopt this guidance as of January 1, 2018. This guidance will not have a material impact on the Company's financial condition, results of operations, or cash flows.
effective for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. The guidance must be applied retrospectively to all periods presented in the statements of cash flows. The Company will adopt this guidance as of January 1, 2018. As result, the net amount of the change in the restricted cash balances during each reporting period will no longer be presented as a discrete line item "Change in restricted cash" within investing cash flows for each applicable period, as is currently reported in the Company's Consolidated Statements of Cash Flows for the years ended December 31, 2017, 2016 and 2015 herein. This guidance will not have an impact on the Company's financial position or results of operations.
In March 2017, the FASB issued an accounting standards update concerning the presentation of costs related to defined benefit pension plans and similar plans. The amendments in this ASU principally require that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered by relevant employees during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. If a separate line item or items are used to present the other components of net benefit cost, that line item or items must be appropriately described. If a separate line item or items are not used, the line item or items used in the income statement to present the other components of net benefit cost must be disclosed. The amendments in the update are effective for public business entities for annual periods beginning after December 15, 2017, including interim periods within those annual periods. The amendments in the ASU relating to presentation in the income statement should be applied retrospectively. Disclosures of the nature of and reason for the change in accounting principle are required in the first interim and annual periods of adoption. The Company will adopt this guidance as of January 1, 2018. This guidance is disclosure-related only, and will not have an impact on the Company's financial position, results of operations or cash flows.
The update also amends existing external disclosure requirements, while easing internal documentation requirements surrounding hedge effectiveness testing. In particular, the initial quantitative effectiveness test may now be prepared within three months of hedge designation, and subsequent tests may be performed on a qualitative basis in certain cases. For public business entities, the amendments in the update are effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early application is permitted in any interim period after issuance of the update. All transition requirements should be applied to hedging relationships existing on the date of adoption. The effect of adoption should be reflected as of the beginning of the fiscal year of adoption. The Company is currently evaluating the impact of this guidance.
On February 14, 2018, the FASB issued an accounting standards update concerning the stranded tax effects resulting from the U.S. Tax Cuts and Jobs Act. Under existing GAAP, the effects of changes in tax rates on deferred tax balances are reflected in income, even if the balances related to items of accumulated other comprehensive income. This update permits a reclassification from accumulated other comprehensive income to retained earnings for such stranded tax effects resulting from the U.S Tax Cuts and Jobs Act. Certain disclosures about stranded tax effects will also be required. The amendments in the update are effective for all entities for fiscal years beginning after December 2018, and interim periods within those financial years. For public business entities, early adoption is permitted, including adoption in any interim period for reporting periods for which financial statements have not yet been issued. The amendments should be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. Tax Cuts and Jobs Act is recognized. The Company is currently evaluating the impact of this guidance.
FII received $3.9 million in proceeds for the sale of 7.8% of the common shares held by FII and 6.4% of preference shares held by FII. The Company recorded a pre-tax gain of $3.5 million as a result of this transaction.
On September 30, 2016, X.L. America, Inc. ("XL America") and XL Life and Annuity Holding Company ("XLLAHC"), both indirect wholly-owned subsidiaries of the Company, completed the previously announced sale of the Company's wholly-owned subsidiary XLLIAC to Mutual of Omaha Insurance Company.
On September 30, 2016, the Company's indirect, wholly-owned subsidiary, Catlin Holdings Limited, completed the acquisition ("Brooklyn Acquisition") of Brooklyn Underwriting Pty Limited and Brooklyn IT Pty Limited (collectively "Brooklyn"). Brooklyn is a specialty underwriting agency in Australia and Lloyd's-approved coverholder, serving brokers across Australia. The Company recorded definite-lived intangible assets of $22.9 million, which is being amortized over their estimated useful lives. See Note 9, "Goodwill and Other Intangible Assets," for further information.
The Company made an initial payment of $75.7 million to acquire Allied. Additional contingent consideration was to be paid based on production and underwriting profitability over a three-year period subsequent to the acquisition date. The Company originally estimated the fair market value of these payments to be $15.0 million, resulting in total consideration of $90.7 million recorded for the acquisition. Due to an agreement reached on April 11, 2017, the target payments of contingent consideration were modified to range from $12.5 million to $20.0 million. At December 31, 2017, the Company estimates the fair value of these payments to be approximately $17.0 million, resulting in an additional $2.0 million of expense recorded as "Fee income and other" in the Consolidated Statements of Income for the year ended December 31, 2017.
XL-Ireland acquired each ordinary share of Catlin, par value $0.01 per share ("Catlin Shares"), for consideration per Catlin Share (the "Acquisition Consideration") equal to 388 pence in cash and 0.130 of an XL-Ireland ordinary share, par value $0.01 per share ("XL-Ireland Shares"), subject to the mix and match facility set forth in the implementation agreement.
XL-Ireland issued approximately 49.9 million XL-Ireland Shares and paid approximately £1.49 billion in cash to the holders of Catlin Shares as Acquisition Consideration.
The purchase price was allocated to the acquired assets and assumed liabilities of Catlin based on estimated fair values on the Acquisition Date. The Company recognized goodwill of $794.0 million, which was primarily attributable to the synergies and economies of scale expected to result from the integration of Catlin into the Company's operations, including further
diversification in the geographic mix and product offerings and an increase in distribution strength. As of December 31, 2015, the allocation of the purchase price reflected an increase of $15.9 million in the amount recorded for current and deferred tax liabilities from the allocation initially reported at June 30, 2015 and a corresponding increase in the amount recorded for goodwill. The Company allocated $466.1 million of this goodwill to its Insurance segment and $327.9 million to its Reinsurance segment. The Company also recognized indefinite-lived intangible assets of $673.0 million and definite-lived intangible assets of $315.0 million, which are being amortized over their estimated useful lives. See Note 9, "Goodwill and Other Intangible Assets," for further information.
The results of the acquired Catlin operations have been included in the Company's consolidated financial statements from the Acquisition Date to December 31, 2015. The following table presents unaudited pro forma consolidated information for the year ended December 31, 2015 and assumes the Catlin Acquisition occurred on January 1, 2014. The pro forma financial information is presented for informational purposes only and does not necessarily reflect the results that would have occurred had the acquisition taken place on January 1, 2014, nor is it necessarily indicative of future results. Significant adjustments used to determine pro forma results include amortization of intangible assets and amortization of fair value adjustments discussed above, and the corresponding income tax effects. Non-recurring transaction related costs noted above have been included in the unaudited pro forma results for the year ended December 31, 2015.
The Company is organized into two operating segments: Insurance and Reinsurance.
The Company's general investment and financing operations are reflected in Corporate and Other. Subsequent to the GCLR transaction described in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation," GCLR reinsures the majority of the Company's life reinsurance business through the GreyCastle Life Retro Arrangements. The results of the run-off life operations not subject to the GreyCastle Life Retro Arrangements are also reported within Corporate and Other.
The Company evaluates the performance of both the Insurance and Reinsurance segments based on underwriting profit. Other items of revenues and expenditures of the Company are not evaluated at the segment level. In addition, the Company does not allocate investment assets used to support its Property and Casualty ("P&C") operations to the individual segments, except as noted below. Investment assets related to the Company's Run-Off Life Operations are held in a separately identified portfolio. Net investment income from these assets is included in the contribution from Corporate and Other. Certain structured products included in the Insurance and Reinsurance segments are also held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from the applicable segment.
The following tables summarize the segment results for the indicated years ended December 31, 2017, 2016 and 2015:
Corporate and Other includes other items of our revenue and expenditures that are not evaluated at the segment level for reporting purposes. The underwriting profit (loss) and its components within this section are predominantly driven from the Company's Run-Off Life Operations.
Net fee income and other includes operating expenses of $49.0 million from the Company's loss prevention consulting services business.
In an effort to improve operational efficiency, the Company has undergone an initiative to transform its investment operations and related reporting. As a result of this initiative, the Company has simplified the classification of its fixed maturity securities by investment type to align its internal and external reporting processes. Corporate securities previously separated into two classifications have been merged into one. Residential mortgage-backed securities have also been merged into a single classification. Collateralized debt obligations are now reported under Other asset-backed securities. Comparative period amounts have been re-presented to conform to the new classification system.
The contractual maturities of AFS and Trading fixed income securities at December 31, 2017 and 2016 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Certain of the Company's invested assets are pledged in support of insurance and reinsurance liabilities as well as to collateralize our credit facilities. Such pledges are largely required by the Company's operating subsidiaries that are "non-admitted" under U.S. state insurance regulations, in order for the U.S. cedant to receive statutory credit for reinsurance. Also included in pledged assets are Life Funds Withheld Assets, as noted in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation." Additionally, certain deposit liabilities and annuity contracts require the use of pledged assets. As of December 31, 2017 and 2016, the Company had $18.8 billion and $17.1 billion in pledged assets, respectively.
The Company had gross unrealized losses totaling $199.3 million on 2,950 securities out of a total of 7,822 held at December 31, 2017 in its AFS - Excluding Life Funds Withheld Assets portfolio, which either it considers to be temporarily impaired or reflects non-credit losses on other-than-temporarily impaired assets. Individual security positions comprising this balance have been evaluated by management, in conjunction with our investment managers, to determine the severity of these impairments and whether they should be considered other-than-temporary. Management believes it is more likely than not that the issuer will be able to fund sufficient principal and interest payments to support the current amortized cost.
The Company's most significant operating affiliate at December 31, 2017 is an investment of $124.2 million in Privilege Underwriters, Inc. and its affiliates ("PURE Group"), an insurance provider specializing in products for high net worth individuals. The PURE Group investments consist of: (i) a $77.5 million purchase of 9.9% of the ordinary common units and preferred units of Privilege Group Holdings LP, and 9.9% of the units of Privilege Group Holdings GP, LLC; and (ii) a total of $50.0 million of purchases, at par value, of ten year surplus notes issued by Privilege Underwriters Reciprocal Exchange. Under the terms of an agreement between the parties, effective January 18, 2018, the PURE Group has exercised its option to require the Company to purchase a remaining $25.0 million of ten year surplus notes, at par.
At December 31, 2017 and 2016, the hedge fund portfolio, accounted for as other investments, employed four strategies as noted above in Note 5, "Investments in Affiliates."
The following represents an analysis of the net unrealized gains for the indicated years ended December 31, 2017 and 2016, and the net realized gains as of December 31, 2017, 2016 and 2015, on the Company's hedge funds and private investments:
Overseas deposits include investments in private funds related to Lloyd's syndicates in which the underlying instruments are primarily government and government-related/supported and corporate fixed income securities. The funds themselves do not trade on an exchange and therefore are not included within AFS securities. Also included in overseas deposits are restricted cash and cash equivalent balances held by Lloyd's syndicates for solvency purposes. Given the restricted nature of these cash balances, they are not included within the cash and cash equivalents category in the Consolidated Balance Sheet.
On June 9, 2009, XL Specialty Insurance Company ("XL Specialty"), a wholly-owned subsidiary of the Company, entered into an agreement with National Indemnity Company, an insurance company subsidiary of Berkshire Hathaway Inc. ("National Indemnity"). Under the agreement, and a related reinsurance agreement, National Indemnity agreed to issue endorsements to certain directors and officers liability insurance policies known as "Side A" coverage policies underwritten by XL Specialty (the "Facility") during an eighteen month period that ended on December 31, 2011.
On July 17, 2009, XLIB purchased notes with an aggregate face amount of $155.0 million. On October 29, 2014, XLIB purchased notes with an aggregate face amount of $81.9 million. The issuer of both series of notes was a structured credit vehicle that held corporate debt and preferred equity securities, including some securities issued by European financial institutions, as well as project finance debt securities, among other assets. During the year ended December 31, 2015 the Company recorded OTTI of $8.6 million. During the fourth quarter of 2015, XLIB entered into transactions whereby it acquired the underlying corporate debt and preferred equity securities in return for the cancellation of the notes. The acquired securities are included in the available for sale fixed maturities and equity securities portfolios. In connection with the cancellation of the notes, the Company recorded realized investment losses of $6.7 million.
The fair value movements in derivative assets and liabilities relating to modified coinsurance and funds withheld contracts are included within the associated asset or liability at each period end on the face of the Consolidated Balance Sheets. Notional amounts associated with reinsurance agreements under which the Company assumes reinsurance risk are recorded as asset derivative notional amounts. Notional amounts associated with the GreyCastle Life Retro Arrangements and other outward reinsurance contracts under which the Company cedes risk are recorded as liability derivative notional amounts. Included in the liability derivative notional amount as of December 31, 2017 is the cumulative net realized and unrealized loss on the life retrocession embedded derivative of $1.1 billion.
As described in Note 14, "Notes Payable and Debt and Financing Arrangements," the Company has issued debt denominated in Euros that is designated and qualifies as a non-derivative hedging instrument against an equal amount of the Company's currency exposure to the Euro resulting from net investments in foreign operations. Accordingly, the foreign currency revaluation of this debt is recorded in AOCI, offsetting the foreign currency translation adjustment of the related net investments that is also recorded in AOCI.
The following table provides the total impact on earnings relating to derivative instruments not formally designated as hedging instruments. The impacts are all recorded through "Net realized and unrealized gains (losses) on derivative instruments" in the Consolidated Statements of Income for the years ended December 31, 2017, 2016 and 2015:
The Company, either directly or through third party investment managers, may use derivative instruments within its investment portfolio, including interest rate swaps and options on interest rate swaps, total return swaps, credit derivatives (including single name and index credit default swaps and options on credit default swaps), equity options, forward contracts and futures (including foreign exchange, bond and stock index, interest rate and commodity futures), primarily as a means of reducing investment risk by economically hedging exposures to interest rate, credit spread, equity price changes and foreign currency risk or, in limited instances, for efficient portfolio management. When using exchange-traded or cleared over-the-counter derivatives, the Company is exposed to the credit risk of the applicable clearing house and of the Company's futures commission merchant. When using uncleared over-the-counter derivatives, the Company is exposed to credit risk in the event of non-performance by the counterparties to such derivative contracts. To manage this risk, the Company requires appropriate legal documentation with counterparties that has been reviewed and negotiated by legal counsel on behalf of the Company and complies with the Company's documentation standards, investment guidelines and policies.
Stock index futures may be purchased within the Company's investment portfolio to create synthetic equity exposure and to add value to the portfolio with overlay strategies where market inefficiencies are believed to exist. Stock index futures may be sold to facilitate the timely and efficient reduction of equity exposure. Equity option strategies, including both purchases and sales of options, may be used to add value or reduce exposure with overlay or other strategies. From time to time, the Company may enter into other financial market exposure derivative contracts on various indices and other underlying financial instruments including, but not limited to, equity options, total return swaps, and commodity contracts.
On January 9, 2015, the Company entered into deal contingent deliverable Foreign Exchange Forwards ("FX Forwards") with Morgan Stanley Capital Services LLC and Goldman Sachs International. The purpose of the FX Forwards was to mitigate the risk of foreign currency exposure related to the Catlin Acquisition. Following the closing of the Catlin Acquisition, the FX Forwards were settled.
The impact of the GreyCastle Life Retro Arrangements on the Company's results for the years ended December 31, 2017, 2016 and 2015 was as follows:
The underwriting profit of $0.6 million in 2015 relates to premium adjustments relating to the GreyCastle Life Retro Arrangements transaction. Excluding these transactions, the impact to comprehensive income relating to the GreyCastle Life Retro Arrangements was nil for the years ended December 31, 2017 and 2016.
As shown in the table above, although the Company's net income (loss) is subject to variability related to the GreyCastle Life Retro Arrangements, there is minimal net impact on the Company's comprehensive income in any period. The life retrocession embedded derivative value includes the interest income, unrealized gains and losses, and realized gains and losses from sales of the Life Funds Withheld Assets.
The Company may designate certain of its derivative instruments as fair value hedges or cash flow hedges, in which case it formally and contemporaneously documents all relationships between the hedging instruments and hedged items and links the hedging derivative to specific assets and liabilities. The Company assesses the effectiveness of the hedge both at inception and on an on-going basis, and determines whether the hedge is highly effective in offsetting changes in fair value or cash flows of the linked hedged item.
Short-term investments consist primarily of U.S. and Non-U.S. Government securities, Corporate securities and Other asset-backed securities.
Cash equivalents balances subject to fair value measurement include certificates of deposit and money market funds. Operating cash balances are not subject to recurring fair value measurement guidance.
Excluded from Other Investments are certain investments that are measured using net asset value as a practical expedient in the amount of $198.2 million and $322.9 million as of December 31, 2017 and December 31, 2016, respectively. Under GAAP, these investments are excluded from the fair value hierarchy table. In addition, the Other investments balance excludes loans held at amortized cost, which totaled $173.0 million at December 31, 2017 and $142.3 million at December 31, 2016. For further information, see Note 6, "Other Investments."
Funds withheld on life retrocession arrangements (net of future policy benefit reserves recoverable) include balances related to the life retrocession embedded derivative, under which all investment results associated with the Life Funds Withheld Assets related to the GreyCastle Life Retro Arrangements described in Note 1(a), "Significant Accounting Policies - Basis of Preparation and Consolidation", accrue to the benefit of GCLR.
Equity securities and other investment securities generally include investments in thinly traded equity funds and fixed income funds (including Overseas Deposits). Fair value is determined based upon prices received from pricing services as well as from net asset values ("NAV") received from the fund administrators.
Funds withheld on GreyCastle Life Retro Arrangements (net of future policy benefit reserves recoverable)
The tables below present additional information about assets and liabilities measured at fair value on a recurring basis and for which Level 3 inputs were utilized to determine fair value. The tables present a reconciliation of the beginning and ending
In general, Level 3 assets include securities for which values were obtained from brokers where either significant inputs were utilized in determining the values that were difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not available to support a Level 2 classification. Transfers into or out of Level 3 primarily arise as a result of the valuations utilized by the Company changing between either those provided by independent pricing services that do not contain significant unobservable inputs and other valuations sourced from brokers that are considered Level 3.
The Company's Level 3 assets consist primarily of U.S. Government securities, Corporates and Other asset-backed securities, for which non-binding broker quotes are the primary source of the valuations. Sufficient information regarding the specific inputs utilized by the brokers was not available to support a Level 2 classification. The Company obtains the majority of broker quotes for these securities from third party investment managers who perform independent verifications of these valuations using pricing matrices based upon information gathered by market traders. In addition, for the majority of these securities, the Company compares the broker quotes to independent valuations obtained from pricing services, which may also consist of broker quotes, to assess if the prices received represent a reasonable estimate of the fair value. Although the Company does not have access to the specific unobservable inputs that may have been used in the fair value measurements of these securities provided by brokers, we would expect that the significant inputs considered are prepayment rates, probability of default, loss severity in the event of default, recovery rates, liquidity premiums and reinvestment rates. Significant increases (decreases) in any of those inputs in isolation could result in a significantly different fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.
The fair values of the Company's notes payable and debt outstanding were determined based on quoted market prices.
The following table presents an analysis of goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2017, 2016 and 2015:
In July 2015, as a result of the transaction described in Note 2(e), "Acquisitions and Disposals - New Energy Risk," the Company recognized additional goodwill of approximately $13.4 million. The transaction was accounted for using the acquisition method under which the Company recorded the identifiable assets acquired and liabilities assumed at their acquisition date fair values, and recorded as goodwill the excess of the sum of a) over b) - in which a) represents the aggregate of: i) the consideration transferred, ii) the fair value of non-controlling interest in the acquiree, and iii) the acquisition-date fair value of the Company's previously held equity interest in the acquiree; and b) represents the net assets acquired in the transaction.
intangible assets, and liabilities assumed, at their Acquisition Date fair values, and recorded the excess of consideration transferred over the net assets acquired as goodwill.
At December 31, 2017 and 2016, the ending definite-lived intangible assets balance is comprised of $354.2 million and $347.2 million, respectively, of gross intangible assets, offset by accumulated amortization of $61.6 million and $39.8 million, respectively. Future amortization expenses of current intangible assets are as follows and will amortize over a weighted average period of 16.7 years:
In connection with the transaction described in Note 2(d), "Acquisitions and Disposals - Allied Acquisition," the Company acquired indefinite-lived intangible assets of $8.0 million and definite-lived intangible assets of $6.0 million, which will be amortized over their estimated useful lives.
With respect to the Insurance segment, 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 Reinsurance 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. For reinsurers, uncertainty in the reserving process stems, in part, from timing lags inherent in reporting by the claimant to the primary insurer, and subsequently by the primary insurer to the reinsurer. As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, the Company is potentially subject to an additional timing lag in the receipt of information, as the primary insurer reports to the broker who in turn reports to the Company.
estimate of IBNR reserves. Finally, the Company also supplements the loss information received from cedants with loss estimates developed by market share techniques and/or from third party catastrophe models applied to exposure data supplied by cedants.
IBNR reserves represent management's best estimate, at a given point in time, of the amount in excess of case reserves that is needed for the future settlement and loss adjustment costs associated with claims incurred. It is possible that the ultimate liability may differ materially from these estimates. Because the ultimate amount of unpaid losses and LAE is uncertain, management believes that quantitative techniques to estimate these amounts are enhanced by professional and managerial judgment. Management reviews the IBNR estimates produced by its actuarial department and determines its best estimate of the liabilities to record in the financial statements. The Company considers this single point estimate to be the mean expected outcome.
Generally, initial actuarial estimates of IBNR reserves not related to a specific event are based on the loss ratio method applied to each class of business. Actual paid losses and case reserves ("reported losses") are subtracted from expected ultimate losses to determine IBNR reserves. Estimates of the initial expected ultimate losses involve management judgment and are based on historical information for that class of business, which includes loss ratios, market conditions, changes in pricing and conditions, underwriting changes, changes in claims emergence, and other factors that may influence expected ultimate losses.
Over time, as greater numbers of claims are reported, actuarial estimates of IBNR are based on the BF method and loss development techniques. The BF method utilizes actual loss data and the expected patterns of loss emergence, combined with an initial expectation of ultimate losses to determine an estimate of ultimate losses. This method may be appropriate when there is limited actual loss data and a relatively less stable pattern of loss emergence. The chain ladder method utilizes actual loss data and expected patterns of loss emergence to determine an estimate of ultimate losses that is independent of the initial expectation of ultimate losses. This method may be appropriate when there is a relatively stable pattern of loss emergence and a relatively larger number of reported claims. Multiple estimates of ultimate losses using a variety of actuarial methods are calculated for each class of business for each year of loss experience. The Company's actuaries look at each class and determine the most appropriate point estimate based on the characteristics of the particular class and other relevant factors, such as historical ultimate loss ratios, the presence of individual large losses, and known occurrences that have not yet resulted in reported losses. Once the actuaries make their determination of the most appropriate point estimate for each class, this information is aggregated and presented to management for review and approval.
The pattern of loss emergence is determined using actuarial analysis and judgment and is based on the historical patterns of the recording of paid and reported losses, as well as industry information. Information that may cause historical patterns to differ from future patterns is considered and reflected in expected patterns as appropriate. For property, marine and aviation insurance, losses are generally reported within 2 to 3 years from the beginning of the accident year. For casualty insurance, loss emergence patterns can vary from 3 years to over 20 years depending on the type of business. For other insurance, loss emergence patterns generally fall within these ranges. For reinsurance business, loss reporting lags the corresponding insurance classes often by at least one quarter due to the need for loss information to flow from the ceding companies generally via
reinsurance intermediaries. Such lags in loss reporting are reflected in the actuary's selections of loss reporting patterns used in establishing our reserves.
Unpaid losses and loss expenses prior to reinsurance recoveries for the years ended December 31, 2017 and 2016 comprise the following:
As noted previously, reserve reviews are carried out on an accident year, underwriting year or report year basis depending on the nature of the business. Typically, reserve reviews are carried out gross of reinsurance with ceded reinsurance recoveries evaluated separately to arrive at net reserves. However, in accordance with accounting guidance, the disclosures presented herein are accident year triangles, presented net of reinsurance recoverables. Underwriting year triangles are converted to an accident year basis using assumptions consistent with the underlying premium earning profiles and considering large losses in their respective accident year. Similarly, ceded reinsurance recoverables are allocated to accident year and class of business in order to present net accident year triangles. While we have compiled the triangles on a best efforts basis, the allocation bases required to develop historical net accident year triangles should be viewed as approximations only.
Within the Insurance segment, there are four business groups: Property; Specialty; Professional; and Casualty and other. Within the Reinsurance segment, all major products fall within two categories: Property and Other Short-Tail Lines, and Casualty and Other Long-Tail Lines. The Company has also provided aggregate triangles for the total Company and the Insurance and Reinsurance segments to reflect the levels at which the Company manages its business.
As discussed in further detail in part (c), except for certain workers’ compensation (including long term disability) liabilities and certain bodily injury liability claims emanating from U.K. exposures, predominantly from the U.K. motor liability portfolio, the Company does not discount its unpaid losses and loss expenses. The development in the tables included herein is presented on a gross of discount basis, reflecting the undiscounted case reserves established using a tabular reserving methodology and the undiscounted IBNR. The amount of discount is then determined for both Case and IBNR reserves and booked accordingly. The amount of discount is included in the reconciliation of the reserves to the Consolidated Balance Sheet.
As a result of the Catlin Acquisition in 2015 as noted in Note 2(f), "Acquisitions and Disposals - Catlin Acquisition, the Company acquired approximately $5.4 billion of unpaid claims liability, net of reinsurance, as well as $101.3 million of unpaid claims liability, net of reinsurance due to the Allied Acquisition in 2016 as noted in Note 2(d), "Acquisitions and Disposals - Allied Acquisition." For purposes of this disclosure, the Company has applied the retrospective method for these acquired reserves, including the combined companies' incurred and paid claim development histories throughout the tables. It should be noted that historical reserves for the acquired businesses were established by the respective companies using methods, assumptions and procedures then in effect which may differ from the Company's current reserving bases.
underlying calculation of prior year development in our financial statements due to the inclusion of historical loss payments as well as reserves and the level of granularity used in the calculation. The differences have been deemed not to be material.
As previously noted, the process of establishing reserves for unpaid P&C claims can be complex and is subject to considerable variability, as it requires the use of judgment to make informed estimates. These estimates are based on numerous factors, and may be revised as additional experience and data become available, as new or improved methodologies are developed or as current laws change. In addition, there is no assurance that conditions and trends that have affected the development of liabilities in the past will continue. This variability may result in either favorable or adverse development in the Incurred Loss and Allocated Loss Expense triangles provided by the Company. The variability experienced to date has been in line with management’s expectations given the underlying business written by the Company. We have provided additional commentary for the individual categories below:
For the Insurance Property category, individual accident years have generally developed favorably as updated loss estimates were received and volatility in the loss estimates decreased. The 2014 accident year experienced adverse development from the 2014 evaluation to the 2015 evaluation due to development on a large fire loss which occurred in late December 2014. The 2014 accident year then developed favorably from the 2015 evaluation to the 2016 evaluation. The 2015 accident year experienced adverse development from the first evaluation in 2015 to the second evaluation in 2016 due to movements on several claims in the international property and construction businesses.
For the Insurance Professional category, individual accident years have both favorable and adverse development across the triangle. These developments relate to the complexity associated with claims in this class of business. In 2008, the Company strengthened its reserves for the 2007 report/accident year due to the developing subprime-credit crisis. Due to the claims-made nature of the underlying Professional policies, the subprime-credit crisis impacted the 2008 to 2012 report years and reserves were re-allocated from the 2007 report year to these later years as claims developed. The cumulative impact of the credit crisis and developing loss trends were more severe than originally expected for these years. The 2014-2016 report years have experienced adverse development due to large loss activity in the international financial lines management liability book and the discontinued design subcontractors default portfolio.
For the Insurance Casualty and Other category, individual accident years have both favorable and adverse development across the triangle. These developments relate to the complexity associated with claims in this class of business and the high
level of attachment of the Company’s excess policies. The 2010 accident year experienced more adverse development than other accident years due to development on the Deepwater Horizon event. The 2013 to 2015 accident years reflect adverse development due to large loss activity relating to the excess casualty portfolio and strengthening of the excess and surplus portfolio and the newly acquired Allied business. The 2016 accident year shows minimal adverse development during 2017.
For the Reinsurance Segment in total, while individual accident years have both favorable and adverse incremental development across the triangle, all accident years except for the 2016 accident year developed favorably since the first evaluation. The modest unfavorable development on the 2016 accident year emanates from the Property and Other Short Tail category as noted below.
For the Reinsurance Property and Other Short Tail category, individual accident years have generally developed favorably as updated loss estimates were received and volatility in the loss estimates decreased. The two outliers were the 2010 and 2012 accident years where there was modest adverse development related to large loss events from the business acquired in the Catlin Acquisition. Specifically, the 2010 adverse development relates to the Buncefield Explosion and the New Zealand Darfield Earthquake offset by more recent favorable developments on other large losses and attritional experience. The 2012 development relates to Costa Concordia and Superstorm Sandy. The favorable development on the 2011 accident year relates in part to reductions on the Japan Earthquake and Tsunami event also within the business acquired in the Catlin Acquisition. As noted earlier, the historical reserves for the acquired businesses were established by the respective companies using methods, assumptions and procedures then in effect which may differ from the Company's current reserving bases. The recent favorable development on 2013 mainly relates to releases on Typhoon Fitow, Central European Floods and favorable attritional experience across all short tailed lines. The unfavorable development on the 2016 accident year relates to deteriorations on the New Zealand Kaikoura Earthquake and Texas Hailstorm events.
For the Reinsurance Casualty and Other Long Tail category, the earlier years had modest favorable development and the later years had modest adverse development. The adverse development for the later accident years relates to changes in reserving methodology for certain long tail lines of business that occurred in calendar years 2012 and 2015. In 2012, the Company changed its methodology to hold an explicit discount on loss reserves for U.K. bodily injury claims expected to settle via Periodical Payment Orders ("PPOs"). As these claims became more prevalent and costly, reserves were strengthened on an undiscounted basis. However, with the implementation of discounting, there was a minimal change in the loss reserves, net of the discount. Similarly, a significant portion of the increase in the Incurred Losses and Allocated Loss Expense, Net of Reinsurance for the 2015 calendar year is due to a change in the methodology used to determine the undiscounted ultimate losses for the reinsurance workers' compensation liabilities acquired in the Catlin Acquisition resulting in a large increase in the undiscounted losses but an insignificant change in the discounted losses. The increase in incurred losses and unallocated loss expenses for the 2017 calendar year is driven by the change in the Ogden discount rate (from 2.5% to -0.75%) used by the courts to determine lump sum compensation for claimants in the UK impacting UK motor, Employer's and General Liability classes. This is partially offset by favorable attritional experience on the North America Casualty book.
As noted in Note 10(c), "Losses and Loss Expenses - Loss Reserve Discounting," the Company discounts only certain workers' compensation (including long term disability) liabilities and certain bodily injury liability claims, emanating from U.K. exposures, predominantly from the U.K. motor liability portfolio.
Net favorable prior year reserve development of $41.8 million for the year ended December 31, 2017 for the Insurance segment. This amount differs from the implied change in ultimate losses that can be calculated from the above triangles because the triangles exclude accident years prior to 2007 as well as minor business and, as noted earlier, utilize a different approach for handling foreign exchange. The total net prior year development of $41.8 million was driven by the following:
Net favorable prior year reserve development totaled $91.5 million for the Insurance segment for the year ended December 31, 2016. Casualty benefited from release in international casualty primarily to reflect better than expected loss experience reported on the general and professional liability portfolios, predominantly on the 2011 and prior years. Better than expected loss experience reported for both catastrophe and non-catastrophe exposures led to release in property. Significant large loss activity on the international financial lines management liability book led to strengthening in professional.
by releases in the excess casualty book and international casualty reflecting better than expected loss experience. Strengthening
The following table summarizes the net (favorable) adverse prior year development by line of business relating to the Reinsurance segment for the years ended December 31, 2017, 2016 and 2015:
Net favorable prior year development for the short-tail lines totaled $140.8 million. Details of the significant components are as follows:
For property other lines, net prior year development was $63.1 million favorable. This was mainly driven by favorable experience on older catastrophes and large losses and better than expected experience on attritional losses.
For specialty lines, net prior year development was $14.6 million favorable. This was mainly due to favorable catastrophe and large loss experience and better than expected development on attritional losses. This was partially offset by strengthening on one large loss in the aviation book.
Net unfavorable prior year development for the long-tail lines totaled $34.8 million. Details of the significant components are as follows:
For casualty lines, net prior year development was $46.3 million unfavorable primarily due to the change in the Ogden discount rate from 2.5% to negative 0.75% and unfavorable development on large losses.
For other lines, net prior year development was $11.6 million favorable largely due to better than expected experience on attritional losses, mainly on the credit and surety book and on the whole account book.
Except for certain workers' compensation (including long term disability) liabilities and certain bodily injury liability claims, emanating from U.K. exposures, predominantly from the U.K. motor liability portfolio, the Company does not discount its unpaid losses and loss expenses.
periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2017 and 2016 on an undiscounted basis were $762.8 million and $727.4 million, respectively. The aggregate discount for the time value of money deducted to derive the liability for unpaid losses and loss expenses were $295.8 million and $287.7 million at December 31, 2017 and 2016, respectively. The related discounted unpaid losses and loss expenses were $467.0 million and $439.7 million at December 31, 2017 and 2016, respectively. The interest accretion related to the unwind of the discounted reserves was $19.2 million and $18.6 million during the years ended December 31, 2017 and 2016, respectively. This interest accretion was recorded in the incurred loss line as adverse prior year development.
The Company records a specific reserve allowance for Periodical Payment Orders ("PPOs") related to bodily injury liability claims. This allowance includes the unpaid losses for claims already settled and notified as PPOs at December 31, 2017, as well as the unpaid losses for claims to be settled in the future. The future care element of the unpaid losses was discounted using an interest rate of 2% at both December 31, 2017 and 2016. Unpaid losses and loss expenses, net of reinsurance, at December 31, 2017 and 2016 on an undiscounted basis were $269.9 million and $281.6 million, respectively. The aggregate discount for the time value of money deducted to derive the liability for the unpaid losses and loss expenses were $119.7 million and $125.9 million at December 31, 2017 and 2016. After discounting the future care element, the unpaid losses and loss expenses were $150.2 million and $155.7 million at December 31, 2017 and 2016, respectively. The decrease in the net undiscounted unpaid losses and loss expenses between December 31, 2017 and 2016 is mainly due to foreign exchange rate movements. The interest accretion related to the unwind of the discounted reserves was $2.8 million during the calendar years ended December 31, 2017 and 2016. This interest accretion was recorded in the incurred loss line as adverse prior year development.
Reinsurance contracts written, both on a proportional and excess basis, after 1972. The Company discontinued writing contracts 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 relate to both traditional products and premises and operations coverage.
During 2006, the Company acquired $40.2 million in losses through a loss portfolio transfer contract of which $18.3 million in losses related to asbestos and environmental claims. Given the terms of the policy, the combined aggregate limit on the total acquired reserves is $60.0 million, not including coverage for claims handling costs over a defined period.
Catlin Acquisition - aviation insurance contracts written by Catlin in the Lloyd's market where the specific asbestos exclusion language was not implemented until 2003. Exposures only extend back to 1993 as Equitas was established to take on the Lloyd's market exposure for 1992 and prior. Exposure is due to asbestos-containing products in use by the aviation industry leading to claims against aviation manufacturers for asbestosis, mesothelioma and lung cancer.
The Company's reserving process includes an ongoing evaluation of the potential impact on unpaid liabilities from exposure to discontinued asbestos and run-off environmental claims, including related loss adjustment expenses. Liabilities are established to cover both known and IBNR claims.
The Company has also reinsured an additional $242.8 million and $270.2 million at December 31, 2017 and 2016, respectively, of its U.S. Term Life future policy benefit reserves ("U.S. Term Life Retro Arrangements"). The Company continues to own, on a funds withheld basis, assets supporting the U.S. Term Life Retro Arrangements. Based upon the contractual right of offset, the funds withheld liability is recorded net of future policy benefit reserves recoverable, and is included within "Reinsurance balances payable" on the Consolidated Balance Sheets.
The effect of reinsurance and retrocessional activity on premiums written and earned from property and casualty operations is shown below:
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $3.2 billion, $1.7 billion and $1.6 billion for the years ended December 31, 2017, 2016 and 2015, respectively.
The following table presents a summary of total reinsurance assets for the years ended December 31, 2017 and 2016:
Reinsurance assets include amounts recoverable from reinsurers on both paid and unpaid losses and loss expenses which are contractual rights subject to credit risk. Amounts recoverable on unpaid losses and loss expenses will not be due for collection until sometime in the future. Economic conditions and operational performance of a particular reinsurer may impact its ability to fully meet these obligations. As such, the collectibility of such amounts requires significant estimation by the Company.
The provision for uncollectible reinsurance on unpaid losses and loss expenses recoverable is established principally based on an analysis of reinsurer credit quality, using default factors derived from reinsurer financial strength ratings. This analysis contemplates collateral in place, which is generally limited to assets held in trust, letters of credit and funds held by the Company with the same legal entity for which the Company believes there is a right of offset. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $6.7 billion and $4.1 billion at December 31, 2017 and 2016, respectively, collateralizing reinsurance recoverables with respect to certain reinsurers.
The following table presents a summary of the Company's allowance for uncollectible reinsurance at December 31, 2017 and 2016:
At December 31, 2017 and 2016, approximately 95.6% and 95.4%, respectively, of the total reinsurance assets, net of collateral held, was due from reinsurers with a financial strength rating of "A" or better. The following table sets forth the ratings profile of the Company's reinsurers at December 31, 2017:
The following is an analysis of the total reinsurance assets, net of collateral held, at December 31, 2017, by reinsurers owing 3% or more of such total:
At December 31, 2017 and 2016, total deposit liabilities were $1.0 billion and $1.1 billion, respectively. For the years ended December 31, 2017, 2016 and 2015, interest expense of $25.3 million, $39.7 million and $42.2 million, respectively, was recorded related to the accretion of deposit liabilities.
On July 7, 2017, the Company repurchased and canceled $16.7 million of the original debt issuance. See below for further details.
The ability of XLIT, like that of the Company, to obtain funds from its subsidiaries to satisfy any of its obligations, including under guarantees, is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which the subsidiaries operate, including, among others, Bermuda, the United States, Ireland, Switzerland and the United Kingdom. For details of the required statutory capital and surplus for the principal operating subsidiaries of the Company, see Item 8, Note 24, "Statutory Financial Data."
On March 30, 2015, XLIT issued $500 million of subordinated notes due March 2045, with a fixed coupon of 5.5%, at 99.115% of the face amount and net proceeds were $488.4 million. Related expenses of the offering amounted to approximately $7.2 million. These costs were deferred and are being amortized over the term of the subordinated notes.
Variable rate unsecured subordinated notes in the amounts of $31 million, $10 million and €11 million due September 2036, issued by Catlin Underwriting, in July 2006. The notes were subordinated to the claims of all senior creditors, as defined in the agreement governing the notes. The notes paid interest at a floating rate based on the rate on three-month deposits in U.S. dollars plus a margin of 310 basis points, 300 basis points and 300 basis points, respectively. Interest was payable quarterly in arrears.
On July 7, 2017, the Company repurchased through a tender offer and canceled $16.7 million outstanding 5.5% Subordinated Notes due 2045 issued by XLIT with a net carrying value of $16.3 million for $17.9 million, inclusive of transaction costs. As a result of this repurchase, the Company recorded a loss of approximately $1.6 million through "(Gain) loss from the early extinguishment of debt" and interest expense of $0.3 million in the Consolidated Statements of Income.
(b) Letter of Credit ("LOC") Facilities and Other Sources of Collateral
Certain credit facilities permit the Company to utilize up to $750.0 million and $1.0 billion as of December 31, 2017 and December 31, 2016, respectively, for revolving loans to support general operating and financing needs. At December 31, 2017 and December 31, 2016, $2.0 million and $245.0 million, respectively, were utilized under these facilities to issue letters of credit, leaving $748.0 million and $755.0 million, respectively, available to support other operating and financing needs.
In November 2015, we entered into four bilateral unsecured credit agreements, each providing for $125 million of letters of credit for Funds at Lloyd's purposes (FAL Facility I, FAL Facility II, FAL Facility III, and FAL Facility IV, collectively the "FAL Facilities") for an aggregate amount of $500 million. Each of the FAL Facilities expires in 2019. The FAL Facilities replaced four unsecured bilateral facilities available for utilization by Catlin Insurance Company Ltd. ("Catlin-Bermuda") for Funds at Lloyd's purposes that we terminated in November 2015.
On August 5, 2016, the Company entered into agreements with a banking syndicate to provide: (a) a new secured credit facility that provides for the issuance of letters of credit up to $750 million (the "Secured Syndicated Facility"), and (b) a new unsecured credit facility that provides for the issuance of letters of credit and revolving credit loans up to $750 million (the "Unsecured Syndicated Facility", and together with the Secured Syndicated Facility, the "Syndicated Facilities"). The Company has the option to increase the maximum amount of letters of credit available under the facilities by $500 million in aggregate across the facilities. In connection with the Syndicated Facilities, the Company's previous syndicated credit agreements originally entered into in November 2013, as well as certain related security arrangements, were terminated. The commitments under the Syndicated Facilities are available until, the earlier of (i) August 5, 2021 (unless extended by the parties), and (ii) the date of termination in whole of the commitments upon an optional termination or reduction of the commitments by the account parties or upon the occurrence of certain events of default.
In November and December of 2016, we entered into two credit agreements with Credit Agricole Corporate and Investment Bank ("Credit Agricole Facility I" and "Credit Agricole Facility II," respectively, and collectively, the "Credit Agricole Facilities"). Each credit agreement provides for the issuance of letters of credit in an amount up to $125 million. The commitments under the Credit Agricole Facilities expire on, and such facilities are available until, the earlier of (i) December 15, 2019, provided that, if neither the Company nor the lender provides notice to the other not more than 90 days, but at least 30 days, prior to such date, the commitment termination date will be extended to December 15, 2020, and (ii) the date of termination in whole of the commitments upon an optional termination or reduction of the commitments by the account parties or upon the occurrence of certain events of default.
On June 19, 2017, the Company entered into a new credit agreement with Commonwealth Bank of Australia, as administrative agent and issuing lender ("2017 Commonwealth Bank Facility"). The capacity available under this standby letter of credit is $215 million. The commitments under the 2017 Commonwealth Bank Facility expire on, and such credit facility is available until, the earlier of (i) September 15, 2020 and (ii) the date of termination in whole of the commitment upon an optional termination or reduction of the commitment by the account party or upon the occurrence of certain events of default.
On September 15, 2017, the Company entered into a new credit agreement with Credit Suisse Bank, as administrative agent and issuing lender ("2017 Credit Suisse Facility"). The capacity available under this standby letter of credit is $100 million. The commitments under the 2017 Credit Suisse Facility expire on, and such credit facility is available until, the earlier of (i) June 19, 2020 and (ii) the date of termination in whole of the commitment upon an optional termination or reduction of the commitment by the account party or upon the occurrence of certain events of default.
The majority of the Company's bank facilities, indentures and other documents relating to the Company's outstanding indebtedness (collectively, the "Company's Debt Documents"), which are described above, contain cross acceleration or cross default provisions to each other and the Company's Debt Documents contain affirmative and negative covenants as well as certain customary events of default. These covenants provide for, among other things, a maximum ratio of total consolidated debt plus consolidated net worth. Generally, each of the Company's Debt Documents provide for an event of default in the event of bankruptcy, insolvency or reorganization of the Company, and the majority of the Company's bank facilities provide an event of default if there is a change of control in the Company.
Given that many of the Company's Debt Documents contain cross acceleration or cross default provisions, a default by one of these subsidiaries may result in all holders declaring their debt due and payable and accelerating all debt due under those documents. If this were to occur, the Company may not have funds sufficient at that time to repay any or all of such indebtedness.
In the normal course of business, the Company enters into assumed reinsurance contracts with certain of its insurance affiliates, or their subsidiaries. During the years ended December 31, 2017, 2016 and 2015, these contracts resulted in reported net premiums, reported net losses, and reported net acquisition costs as summarized below.
Results through April 1, 2015 include amounts under an assumed reinsurance contract with a wholly-owned subsidiary of ARX, an insurance operating affiliate of the Company through that date. The Company disposed of its investment in ARX on April 1, 2015, and thus, after that date, all amounts under this contract are no longer reported as related party transactions. See Note 2(g), "Acquisitions and Disposals - Sale of Operating Affiliate."
Commencing in 2014, several of the Company's wholly-owned subsidiaries retroceded assumed reinsurance business to special purpose reinsurers that receive capital from funds managed by the Company's subsidiary, New Ocean Capital Management ("New Ocean"), as discussed in Note 16, "Variable Interest Entities." Underwriting administration services are provided to the special purpose reinsurers by other subsidiaries of the Company under service fee agreements, while investment advisory services are provided by New Ocean. During the year ended December 31, 2017, ceded premiums earned, ceded losses and loss expenses incurred, ceding commission income, and other fee income related to these retrocessional contracts were not material to the Company.
In April 2015, the Company announced the creation and sponsorship of the XL Innovate Fund, LP ("XL Innovate"), a venture capital initiative with a strategic focus on developing new capabilities in the insurance sector. The majority of XL Innovate's initial capital was financed by the Company. XL Innovate primarily seeks investments in equity positions of entities that provide new market opportunities for the Company throughout the world, striving to create partnerships outside of the traditional underwriting space to find ways to underwrite currently uninsured risks. The family trust of an employee of the Company owns a 5.21% non-controlling equity interest in XL Innovate. The employee serves as a member of the board of directors of both New Energy and XL Innovate, and maintains responsibility over the business generated by it. The underlying investments held by XL Innovate are reflected in the Company's Consolidated Financial Statements in accordance with the Accounting Policies provided in Note 1, "Significant Accounting Policies," based on the Company's level of investment in, and control over, such entities. Aside from investments made where the employee's family trust maintains non-controlling interest, there were no other material transactions between the Company and this employee for the year ended December 31, 2017.
At times, the Company has utilized VIEs both indirectly and directly in the ordinary course of the Company's business. Within its investment portfolio, the Company has holdings in hedge funds, private equity entities and other investment vehicles. A number of these vehicles are considered VIEs based on their legal form and the generally passive role of their investors. As the Company lacks the ability to control the activities that most significantly impact the economic performance of these VIEs, the Company is not considered the primary beneficiary and does not consolidate these entities. The activities of the entities are generally limited to holding investments. The exposure to loss from these investments is limited to the carrying value of the investments at the balance sheet date.
In 2013, the Company, along with other investors, formed New Ocean to act as an investment manager that focuses on providing third-party investors access to insurance-linked securities and other insurance and reinsurance capital markets products. The Company holds a majority voting interest in New Ocean through its ownership of common shares and, accordingly, the financial statements of New Ocean have been included in the Consolidated Financial Statements of the Company. None of the assets, liabilities, revenues or net income of New Ocean were material to the Company during the current year. The equity interest attributable to third party investors in New Ocean recorded in the Company's Consolidated Balance Sheets as "Non-controlling interest in equity of consolidated subsidiaries" was $0.5 million and $1.0 million at December 31, 2017 and December 31, 2016, respectively.
In 2014, New Ocean FCFL invested in a special purpose Bermuda reinsurer, Vector Reinsurance Ltd ("Vector Re"), which was formed for the purpose of underwriting collateralized excess-of-loss reinsurance with a focus on global property catastrophe risks. In the first quarter of 2015, New Ocean MVCFL also invested in Vector Re. Most of Vector Re's current underwriting activity relates to reinsurance business assumed from the Company's subsidiaries. Underwriting administration and claims services are provided to Vector Re by the Company under service fee contracts, while investment advisory services are provided by New Ocean.
The Company currently holds a controlling financial interests in New Ocean FCFL and New Ocean MVCFL, and by extension, Vector Re. Accordingly, the total net assets of New Ocean FCFL, New Ocean MVCFL and Vector Re are included in the Consolidated Financial Statements of the Company as noted below. The Company's shares of revenue and net income in these VIEs were not material to the Company for the year ended December 31, 2017. All inter-company transactions between the Company's entities have been eliminated in consolidation.
The Company has qualified defined contribution plans that are managed externally and to which employees and the Company contribute a certain percentage of the employee's pensionable salary each month. The Company's contribution generally vests after an employee has been with the Company for five years. The Company's expenses for its qualified contributory defined contribution retirement plans were $73.5 million, $88.3 million and $87.5 million at December 31, 2017, 2016 and 2015, respectively.
A qualified non-contributory defined benefit pension plan exists to cover a number of U.S. employees. The plan was curtailed in 2002 and was closed to new entrants at that time. Under the terms of the curtailment, existing plan participants were no longer entitled to earn additional defined benefits for future services performed after the curtailment date; however, accrued benefits are eligible for annual cost-of-living increases. This plan also includes a non-qualified supplemental defined benefit plan designed to compensate individuals to the extent that their benefits under the Company's qualified plan are curtailed due to IRS Code limitations. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee's last ten years of employment.
In addition, pursuant to agreements entered into by the Company, certain former employees have received benefit type guarantees, not formally a part of any established plan. The liability recorded with respect to these agreements at each of December 31, 2017 and 2016 was $2.4 million and $2.3 million respectively, representing the entire unfunded projected benefit obligations.
Certain contributory defined benefit pension plans exist in Germany which are closed to new entrants. Benefits are generally based on length of service and compensation defined in the related agreements.
The components of the net benefit cost for the years ended December 31, 2017, 2016 and 2015 are as follows:
Several assumptions and statistical variables are used in the models to calculate the expenses and liability related to the plans. The Company, in consultation with its actuaries, determines assumptions about the discount rate, the expected rate of return on plan assets and the rate of compensation increase. The table below includes disclosure of these rates on a weighted-average basis, for the years ended December 31, 2017 and 2016 as indicated:
The U.S. Plan assets at December 31, 2017 and 2016 consist of three mutual funds. The first fund seeks long-term capital appreciation by investing in both other equity mutual funds and direct equity securities, with a focus on companies in the U.S., other developed countries and emerging markets. While the fund primarily invests in large companies, it may have exposure to companies in all market capitalization ranges.
The second fund invests primarily in U.S. government, U.S. government agency, and investment grade corporate bonds. The fund employs a high total investment return through a combination of current income and capital appreciation.
The fair value of the U.S. Plan assets at December 31, 2017 and 2016 was $42.7 million and $38.7 million, respectively. As the investments of the retirement plan are mutual funds, they fall within Level 1 in the fair value hierarchy. The inputs and methodologies used in determining the fair value of these assets are consistent with those used to measure our assets as set out in Note 8, "Fair Value Measurements."
The U.K. pension plan assets, including those acquired as part of the Catlin Acquisition, are held in a separate trustee-administered fund to meet long term liabilities to past and present employees. The table below shows the composition of the plans' assets and the fair value of each major category of plan assets at December 31, 2017 and 2016, as well as the potential returns of the different asset classes. The totals of the asset values held in various externally managed portfolios are provided by third party pricing vendors. There is no significant concentration of risk within plan assets. The assets in the plans and the expected rates of return were as follows:
The Company's U.K. plan administered for employees who joined prior to the Catlin Acquisition is subject to triennial funding valuations, the most recent of which was conducted as of June 30, 2015 and was reported in 2016. The $1.0 million deficit (calculated on a realistic basis) is being funded over a 4-year period.
In addition, the Company underwrites a significant amount of its insurance and reinsurance property and casualty 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, 2017, 2016 and 2015, P&C gross written premiums generated from or placed by the below companies individually accounted for more than 10% of the Company's consolidated gross written premiums from P&C operations, as follows:
These brokers are large, well established companies and there are no indications that any of them are financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from P&C operations in any of the three years ended December 31, 2017, 2016 and 2015.
The Company has committed to invest in certain private equity and private credit limited partnerships, limited liability companies or similar structures. At December 31, 2017, the Company had unfunded commitments with these entities totaling $82.6 million over a weighted average period of 6.5 years.
The Company has committed to invest in certain private equity and private credit limited partnerships, limited liability companies or similar structures where it accounts for its holdings in these structures under the equity method. At December 31, 2017, the Company had unfunded commitments with these entities totaling to $308.0 million over a weighted average period of 5.1 years.
The Company rents space for certain of its offices under leases that expire through 2031. Total rent expense under operating leases for the years ended December 31, 2017, 2016 and 2015 was approximately $76.3 million, $68.0 million and $71.1 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
If management believes that, based on available information, it is at least reasonably possible that a material loss (or additional material loss in excess of any accrual) will be incurred in connection with any legal actions other than claims proceedings, the Company discloses an estimate of the possible loss or range of loss, either individually or in the aggregate, as appropriate, if such an estimate can be made, or discloses that an estimate cannot be made. Based on the Company's assessment at December 31, 2017, no such disclosures were considered necessary.
The authorized share capital of XL Group is $9,999,900, divided into: (i) 500,000,000 common shares, par value $0.01 per share and (ii) 499,990,000 shares, par value $0.01 per share. Holders of common shares are entitled to one vote for each share.
On May 13, 2016, XL-Ireland announced that its Board of Directors approved a share buyback program that authorizes the purchase of up to $1.0 billion of XL-Ireland shares (the "May 2016 Program"). As a result of the Redomestication, XL Group assumed the May 2016 Program. Prior to the cancellation and replacement of this program as noted below, during the year ended December 31, 2017, the Company purchased and canceled 2.6 million XL Group shares under the May 2016 Program for $100.0 million.
On February 17, 2017, XL Group announced that its Board of Directors approved a new share buyback program, authorizing the purchase of up to $1.0 billion of XL Group shares (the "February 2017 Program"). This authorization also canceled approximately $349.0 million remaining under the May 2016 Program. During the year ended December 31, 2017, the Company purchased and canceled 11.2 million shares under the February 2017 Program for $470.9 million. At December 31, 2017, $529.1 million remained available for purchase under the February 2017 Program.
On October 15, 2011, XLIT issued $350 million Series D Preference Ordinary Shares. Dividends on the Series D Preference Ordinary Shares are declared and paid quarterly at a floating rate of three-month LIBOR plus 3.120% on the liquidation preference.
On July 7, 2017, the Company repurchased through a tender offer and canceled 27,205 of the outstanding Series D Preference Ordinary Shares of XLIT ("Series D Preference Shares") with a net carrying value of $27.1 million for $25.8 million, inclusive of transaction costs and other consideration. Additionally, on August 23, 2017, the Company repurchased through private placement an additional 30,652 of the outstanding Series D Preference Shares with a net carrying value of $30.6 million for $29.5 million, inclusive of transaction costs and other consideration. As a result of these repurchases, the Company recorded a gain of $2.4 million through "Non-controlling interests" in the Consolidated Statements of Income.
On March 15, 2007, XLIT issued 1.0 million Fixed/Floating Series E Perpetual Non-Cumulative preference ordinary shares, par value $0.01 each, with liquidation preference value of $1,000 per share (the "Series E Preference Ordinary Shares"). The Series E Preference Ordinary Shares are perpetual securities with no fixed maturity date. Dividends on the Series E Preference Ordinary Shares are declared and paid semi-annually at a rate of $32.50 per share.
On July 7, 2017, the Company repurchased through a tender offer 46,635 of the outstanding CICL Prefs with a net carrying value of $43.7 million for $45.6 million, inclusive of transaction costs and other consideration. The preference shares were canceled on July 19, 2017. As a result of these repurchases, the Company recorded a loss of $1.9 million through "Non-controlling interests" in the Consolidated Statements of Income.
The Company's performance incentive programs provide for grants of stock options, restricted stock, restricted stock units, performance units and stock appreciation rights. Share-based compensation granted by the Company generally contains a vesting period of three or four years, and certain awards also contain performance conditions. The Company records compensation expense related to each award over its vesting period, incorporating the best estimate of the expected outcome of performance conditions where applicable. Compensation expense is generally recorded on a straight line basis over the vesting period of an award.
The risk free interest rate is based on U.S. Treasury rates. The expected lives are estimated using the historical exercise behavior of grant recipients. The expected volatility is determined based upon a combination of the historical volatility of the Company's stock and the implied volatility derived from publicly traded options.
The following is a summary of the activity in the stock option plans for the indicated years ended December 31, 2017, 2016 and 2015:
The following is a summary of the stock options outstanding at December 31, 2017, and related activity for the year then ended:
Non-vested restricted stock awards at December 31, 2017 and for the year then ended were as follows:
A summary of the restricted stock units issued to officers of the Company and its subsidiaries for the indicated years ended December 31, 2017, 2016 and 2015 is as follows:
The performance units issued in 2017 vest after approximately three years, subject to the achievement of stated market metrics, and entitle the holder to XL Group shares. Each grant of performance units has a target number of XL Group shares, with final payouts ranging from 0% to 200% of the grant amount depending upon the achievement of stated market metrics along with each employee's continued service through the vesting date. Performance units issued prior to 2017 have a similar vesting schedule and a similar target of shares, but vesting and payout are dependent upon the achievement of stated relative and absolute financial performance metrics along with each employee's continued service through the vesting date. Furthermore, performance units granted in 2017 were granted at the closing market price on the day of grant and entitle the holder to receive dividends declared and paid in the form of additional XL Group shares contingent upon vesting. A summary of the performance units issued to certain employees of the Company for the years ended December 31, 2017, 2016 and 2015 is as follows:
Total unrecognized stock-based compensation expense related to non-vested performance units was approximately $20.1 million at December 31, 2017, which is related to approximately 0.9 million performance units and is expected to be recognized over 1.8 years. Non-vested restricted performance units as of December 31, 2017 were as follows:
In 2017, four quarterly dividends of $0.22 per share were paid to all XL Group common shareholders of record at March 15, June 15, September 15, and December 15. In 2016, four quarterly dividends of $0.20 per share were paid to all XL-Ireland ordinary shareholders of record at March 15 and June 15, and XL Group common shareholders of record at each of September 15 and December 15. In 2015, two quarterly dividends of $0.16 were paid to XL-Ireland ordinary shareholders of record at each of March 13 and June 15 and two quarterly dividends of $0.20 per share were paid to all XL-Ireland ordinary shareholders of record at each of September 15 and December 15.
The Company conducts global operations through its subsidiaries in various jurisdictions around the world, including but not limited to Bermuda, the U.S., the U.K., Switzerland, Ireland, France, Germany, Italy, and Spain. The Company is subject to tax in accordance with the relevant tax laws and regulations governing taxation in the jurisdictions in which it operates.
The income tax provisions for the years ended December 31, 2017, 2016 and 2015 are as follows:
The statutory corporate income tax rate is 15.00%. However, including applicable surcharges and local trade tax, which can vary by location, would increase the combined statutory rate to approximately 33%.
The 12.50% statutory corporate income tax rate applies to active income from the conduct of a trade in Ireland. For passive income or income from other defined activities the statutory rate increases to 25%.
Represents the combined federal and cantonal rate primarily applicable to the Company's Swiss entities.
The statutory rate is 19% effective April 1, 2017. However, from January 1, through March 31, 2017 the statutory rate is 20%. Due to this change of rate, the average statutory tax rate for 2017 is 19.25%.
Significant components of the Company's deferred tax assets and liabilities at December 31, 2017 and 2016 were as follows:
The decrease in the valuation allowance in 2017 of $28.8 million was primarily driven by the revaluation of U.S. capital loss related deferred tax assets, in conformity with U.S. Tax Cuts and Jobs Act, for which a valuation allowance is held. The increase in the valuation allowance in Germany is due to a reduction in deferred tax liabilities that were supporting the recognition of deferred tax assets. This effect was partially offset by valuation allowance decreases in Austria and Italy due to improved profit forecasts, and a decrease in Ireland due to receipt of tax clearance related to the pending dissolution of an entity.
These net operating loss carryforwards relate to a former Irish tax resident company which is in the process of withdrawing from Ireland. Any remaining unused loss carryforward, and the related valuation allowance, will be eliminated at the time of the receipt of tax clearance.
Net operating losses of $4.0 million and $31.8 million will expire in 2018 and 2019, respectively, with the remaining $146.0 million expiring through 2025.
Approximately $47.0 million of the net operating loss carryforwards is subject to restrictions on timing and utilization under §382 of the IRS Code.
The following table summarizes the capital loss carryforwards the Company had at December 31, 2017:
Capital loss carryforwards of $41.2 million will expire at the end of 2018 with another $103.5 million expiring in future years through 2021.
The Company's policy is to recognize any interest and penalties related to unrecognized tax benefits as a component of tax expense. For the years ended December 31, 2017, 2016 and 2015, the Company had accrued interest and penalties of $3.8 million, $0.9 million and $0.4 million, respectively.
Statutory capital and surplus for the principal operating subsidiaries of the Company for the years ended December 31, 2017 and 2016 are summarized below:
Required statutory capital and surplus represents 100% Risk-Based Capital level for principal U.S. operating subsidiaries.
Under the Insurance Act 1978, amendments thereto and related regulations of Bermuda, Class 4 (re)insurers are prohibited from declaring or paying dividends of more than 25% of each of their prior year's statutory capital and surplus unless they file with the BMA an affidavit stating that the dividend has not caused the Class 4 (re)insurer to fail to meet its relevant margins. At December 31, 2017 and 2016, the maximum dividend that our Bermuda Class 4 (re)insurers could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus and liquidity requirements, was approximately $3.1 billion and $3.2 billion, respectively. No Class 4 (re)insurer may reduce its total statutory capital by 15% or more unless it has received the prior approval of the BMA, and it must also submit an affidavit stating that the proposed reduction will not cause it to fail to meet its minimum solvency margin or minimum liquidity ratio.
The Company has two lead property and casualty subsidiaries in the U.S., XLRA and Catlin Specialty Insurance Company ("CSIC"), which are domiciled in the States of New York and Delaware, respectively. Both XLRA and CSIC are the lead companies in their respective insurance pools. Including the pool leaders, these insurance pools include seven and three P&C companies, respectively. The Company also has another property and casualty subsidiary, T.H.E. Insurance Company ("THE"), a Louisiana-domiciled insurer which was acquired as part of the transaction described in Note 2(d), "Acquisitions and Disposals - Allied Acquisition, and exists outside of the existing pools at December 31, 2017.
Unless permitted by the New York Superintendent of Financial Services, XLRA cannot declare or distribute any dividend to shareholders during any twelve month period that exceeds the lesser of 10 percent of XLRA's statutory policyholders' surplus or 100 percent of its "adjusted net investment income," as defined. The New York State insurance laws also provide that any distribution that is a dividend may only be paid out of statutory earned surplus. At December 31, 2017 and 2016, XLRA had negative statutory earned surplus of $138.9 million and an earned surplus of $66.9 million, respectively. At December 31, 2017, XLRA's statutory policyholders' surplus was $2.1 billion, and no dividends can be declared and paid in 2018 without prior regulatory approval. At December 31, 2017 and 2016, five and one, respectively, of the seven P&C members of the XLRA insurance pool had a negative statutory earned surplus.
Unless permitted by the Insurance Commissioner of the State of Delaware, CSIC cannot declare or distribute any dividend to shareholders during any twelve month period that exceeds the greater of 10 percent of statutory policyholders' surplus or 100 percent of net income excluding realized gains. The Delaware State insurance laws also provide that any distribution that is a dividend may only be paid out of statutory earned surplus. At December 31, 2017 and 2016, CSIC had a negative statutory earned surplus of $10.1 million and an earned surplus of $3.4 million, respectively. At December 31, 2017, CSIC's statutory policyholders' surplus was $243.6 million, and no dividends can be declared and paid in 2018 without prior regulatory approval. At December 31, 2017, all three of the P&C members of the CSIC insurance pool had a negative statutory earned surplus.
Unless permitted by the Insurance Commissioner of the State of Louisiana, THE cannot declare or distribute any dividend to shareholders during any twelve month period that exceeds the greater of 10 percent of statutory policyholders' surplus or 100 percent of net income excluding realized gains. At December 31, 2017, THE's statutory policyholders' surplus was $53.3 million, and no dividends can be declared and paid in 2018 without regulatory approval.
XL Group and XLIT have no operations of their own and their assets consist primarily of investments in subsidiaries. Accordingly, XL Group's and XLIT's future cash flows largely depend on the availability of dividends or other permissible payments from subsidiaries as noted above.
XL Group is subject to certain legal constraints that affect its ability to pay dividends on or redeem or buyback its common shares. Under Bermuda law, XL Group may not declare or pay a dividend or make a distribution out of contributed surplus if
In addition, XLIT is subject to certain constraints that affect its ability to pay dividends on its preferred shares. Under Cayman Islands law, XLIT may not declare or pay a dividend if there are reasonable grounds for believing that XLIT is, or would after the payment be, unable to pay its liabilities as they become due in the ordinary course of business. Also, the terms of XLIT's preferred shares prohibit declaring or paying dividends on the common shares unless full dividends have been declared and paid on the outstanding preferred shares. Full dividends have been declared and paid on the outstanding preferred shares at December 31, 2017.
The following is a summary of the unaudited quarterly financial data for 2017 and 2016:
Results for the period include XL-Ireland, which prior to the Redomestication was the ultimate parent and is now in liquidation proceedings as outlined in Note 1, "Significant Accounting Policies." The Company expects the net assets of XL-Ireland to ultimately be distributed to XL Group upon completion of the liquidation.