Total rent expense for the years ended December 31, 2007, 2006 and 2005 was $34.5 million, $35.8 million and $34.9 million, respectively. See Item 8, Note 18(d) to the Consolidated Financial Statements, “Commitments and Contingencies - Properties,” for discussion of the Company’s lease commitments for real property.
Net income per ordinary share is based on the basic and diluted weighted average number of Class A ordinary shares and share equivalents outstanding for each period. Net loss per ordinary share is based on the basic weighted average number of ordinary shares outstanding.
The underwriting expense ratio related to the property and casualty operations is the sum of acquisition expenses and operating expenses for the Insurance and Reinsurance segments divided by net premiums earned for the Insurance and Reinsurance segments. See Item 8, Note 4 to the Consolidated Financial Statements, “Segment Information”, for further information.
Certain reclassifications to prior period information have been made to conform to current year presentation.
This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements which involve inherent risks and uncertainties. Statements that are not historical facts, including statements about the Company’s beliefs and expectations, are forward-looking statements. These statements are based upon current plans, estimates and expectations. Actual results may differ materially from those projected in such forward-looking statements, and therefore undue reliance should not be placed on them. See “Cautionary Note Regarding Forward-Looking Statements” for a list of additional factors that could cause actual results to differ materially from those contained in any forward-looking statement.
Following the significant natural catastrophes of 2005, additional competitors were formed in the marketplace which had the effect of increasing the available capacity within the insurance and reinsurance markets during 2006. Although rates within some lines of business, such as catastrophe exposed property, experienced increases, an overall increasingly competitive environment and the entrance of these new competitors had a dampening effect on rates within many property and casualty lines of business, which ultimately contributed to reducing gross and net premiums written in 2006.
During 2007, all lines of business within the Insurance segment continued to experience rate declines as well as increased competition as the insurance market continued to soften. Rate changes on business renewed varied by line of business with decreases ranging from roughly 1% to 11%. Premiums were also reduced over 2006 by the decision not to renew ICAT, a program which offered property catastrophe insurance primarily to small business customers. The Insurance segment wrote some new business lines, notably Excess & Surplus lines and Private Company Directors and Officers’ insurance, both in the U.S. Customer retentions ratios were generally consistent with historic levels, with the exception of lines in which deliberate action had been taken to reduce exposure, primarily in catastrophe-prone businesses. The Insurance segment also saw an increase in the volume of long-term agreements compared with the previous year, most notably in casualty lines of business, and also benefited from changes in foreign exchange rates.
The following table provides an analysis of gross premiums written, net premiums written and net premiums earned for the Insurance segment for the last three years ended December 31:
In 2006, the Company’s net investment income increased primarily due to the increase in the size of the investment portfolio and also a rise in the level of the U.S., U.K., and Euro zone interest rates. In 2006, the Company generated net realized losses from its investment portfolio primarily due to other-than-temporary impairments. Net gains from the equity and non-U.S. dollar fixed income portfolios were offset by net losses on U.S. dollar fixed income portfolios, reflecting higher U.S. interest rates. In 2005, the Company generated net realized gains from both its equity and fixed income portfolios, reflecting the then current and accumulated performance of the capital markets.
The following are some of the financial measures management considers important in evaluating the Company’s operating performance in the Company’s property and casualty operations:
Net investment income related to property and casualty operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed income securities. Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and changes in overall asset allocation. The increase in net investment income in 2007, 2006 and 2005 is primarily due to several years of positive operating cash flows which have resulted in a higher overall average invested asset base. In addition, during 2007, portfolio yields increased in the Company’s investment portfolio, due primarily to the full 2007 financial year impact of the higher interest rates experienced in the U.S., U.K. and Euro-zone, during the latter part of 2006 and the beginning part of 2007. In 2007, the U.S. yield curve shifted downwards with short-term U.S. interest rates decreasing markedly while medium to long-term interest rates experienced a less dramatic fall. U.K. interest rates also decreased in 2007 with the exception of long-term U.K. interest rates which rose slightly, while Euro-zone interest rates increased in 2007. In 2006, the U.S. yield curve shifted upwards with short-term U.S. interest rates increasing markedly while medium to long-term interest rates had a less dramatic rise. U.K. and the Euro zone interest rates also increased in 2006.
Management also views the change in the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income (loss), by any changes in the net unrealized gains and losses on its investment portfolio, currency translation adjustments and also the impact of any share repurchase or issuance activity. Book value per ordinary share has decreased by $2.82 during the year ended December 31, 2007 to $50.30 from $53.12, as compared to an increase of $8.81 in 2006. The decrease in book value per share in 2007 was primarily as a result of an increase in net unrealized losses on investments of $743.0 million, net of tax, partially offset by net income of $206.4 million for the year ended December 31, 2007, which increased book value, together with an increase in currency translation adjustments due to the impact of the decline in the value of the U.S. dollar on the net assets of European-based subsidiaries. The increase in unrealized losses on investments was primarily as a result of widening credit spreads on corporate and structured credit assets, partially offset by declining U.S. and U.K. government interest rates in 2007. In addition, certain capital
Book value per ordinary share increased in 2006 mainly due to net income of $1.7 billion and was offset by decreases of $103.8 million, net of tax, in net unrealized gains associated with the Company’s investment portfolio. The decrease in net unrealized gains in 2006 was generally due to interest rate increases, which were offset by the positive impact of equity and currency movements.
Return on average ordinary shareholder’s equity (“ROE”) is another financial measure that management considers important in evaluating the Company’s operating performance. ROE is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes minimum target ROEs for its total operations, segments and lines of business. If the Company’s minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit these lines. In addition, the Company’s compensation of its senior officers is significantly dependent on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE (adjusted for certain items considered to be ‘non-operating’ in nature). In 2007, ROE was 2.2 %, 17.4 percentage points lower than the prior year, primarily as a result of losses recorded in the second half of 2007 in relation to adverse credit market conditions, including but not limited to, losses associated with the Company’s investment in and reinsurance agreements with SCA and realized losses, including OTTI, on the Company’s investment portfolio. For further details of these losses, see “Results of Operations” below. Partially offsetting these decreases were strong underwriting results in 2007 within the Company’s core property and casualty operations and lower levels of shareholders equity resulting from capital activity and increases in unrealized losses on investments. In 2006, ROE was 19.6% due to solid underwriting results throughout its property and casualty operations combined with investment and affiliate income.
The Company’s net income (loss) and other financial measures as shown above for the three years ended December 31 have been affected by among other things, the following significant items:
The Company has multiple relationships with SCA as a result of SCA’s initial origins as a wholly-owned subsidiary and its subsequent IPO. These relationships are detailed in Note 3 to the Consolidated Financial Statements, “Security Capital Assurance”, and include, most significantly, a 46% investment along with certain guarantees and reinsurance arrangements. The Company is not a primary originator or insurer of mortgages, nor does it guarantee mortgages other than indirectly through the activities of SCA, and as such the negative impact to the Company during the year with respect to deterioration in the credit markets and its impact on credit enhancement activities is largely limited to the SCA investment and related reinsurance agreements and guarantees.
As of December 31, 2007, the Company’s total net exposure under its facultative agreements with SCA subsidiaries was approximately $7.7 billion of net par outstanding. Of this total, $138.0 million and $769.0 million of net par outstanding was related to RMBS and ABS CDOs, with greater than 50% RMBS collateral, respectively. Based on the Company’s examination of exposures under these facultative agreements, the Company has reported loss reserves of $51.0 million on a net present value basis.
* As of December 31, 2007, $1.8 billion of the total $7.7 billion in net par outstanding was originally written by SCA in credit derivative form.
In addition, there are certain guarantees in place between the Company and SCA subsidiaries. It is important to note that the guarantees the Company has provided contain a dual trigger, such that losses are paid only if two events occur. First, the underlying guaranteed obligation must default on payments of interest and principal, and second, the relevant SCA subsidiary must fail to meet its obligations under the applicable reinsurance or guarantee. As of December 31, 2007, the Company’s total net par outstanding under these guarantees was $75.2 billion. Indirect consumer mortgages exposures as a result of these guarantee agreements totaled approximately $2.9 billion related to RMBS and $3.3 billion related to ABS CDOs with greater than 50% RMBS collateral. Again, it is important to note that SCA subsidiaries must fail to meet their obligations under the applicable reinsurance or guarantee before the Company would be required to respond to claims under these guarantees and as such, these exposures must be compared to the relevant SCA subsidiary’s current financial resources.
The Company’s management has been diligently engaged in market developments and has reduced the Company’s exposure to lower rated investment grade 2005, 2006 and 2007 vintage sub-prime securities given concerns about future deterioration. Management has performed in depth analyses of the Company’s holdings in all of the “topical asset” classes, which are defined to be structured assets with underlying collateral of sub-prime first liens, Alt-A, second liens, and asset-backed CDOs with sub-prime collateral. In addition to extensive holding level reviews with the Company’s third party managers, the Company has undertaken an independent evaluation of its topical assets to help further identify areas of potential economic loss to principal due to potentially deteriorating underlying fundamentals.
These market developments have negatively impacted the Company’s results from operations through both impairment charges and realized losses largely in the specialised mortgage portfolios, spread business portfolios, losses related to exposure to the capital notes of a structured investment vehicle (“SIV”) and a loss recorded by one of the Company’s investment manager affiliates.
Net realized and unrealized losses on investment derivatives for 2007 resulted primarily from a mark-to-market loss of $37.0 million in the third quarter with respect to a total return swap on an SIV impacted by the challenging credit markets. During the fourth quarter, the Company terminated the swap, recognized an additional $3.9 million mark-to-market loss and took delivery of the underlying asset. The asset was subsequently written off to nil in the fourth quarter resulting in a realized loss on investments of $57.3 million.
Much of the negative impact of credit markets during 2007 was contained in the Company’s Other Financial Lines segment which comprises the GIC and FA businesses which are largely credit spread activities and have a higher component of floating rate structured credit assets. During 2007, net realized losses and impairments within the Other Financial Lines segment totaled $370.7 million and net unrealized losses increased by $329.6 million.
In addition to the impact on net income, the Company’s book value also declined through the increase of net unrealized losses on the portfolio as a whole as a result of the overall widening of global credit spreads on corporate and structured credit assets, partially offset by declining U.S. and U.K. government interest rates for the year.
During 2007, the Company had net favorable prior year reserve development in property and casualty operations of $425.4 million compared to net favorable prior year reserve development of $110.6 million for the same period in 2006. Reinsurance net favorable development accounted for $267.3 million of the release in 2007, while net favorable development within the Insurance segment totaled $158.1 million for the same period. The corresponding prior year development on a gross basis was $259.7 million for the Reinsurance segment and $177.6 million for the Insurance segment.
The Insurance segment net prior year reserve releases consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively. Casualty releases relate primarily to the European casualty portfolio in accident years 2002-2005. The professional lines development reflects net adverse development of the Bermuda E&O portfolio and releases from the U.S. and European professional lines portfolios. Strengthening in other insurance lines relates to net adverse prior year development in discontinued specialty lines, surety and environmental, partially offset by favorable development in aerospace and political risk.
Within the Reinsurance segment, reserve releases of $188.7 million in property and other short-tail lines of business and $87.4 million in casualty and other lines, was partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. Releases in the short-tail lines relate primarily to the 2005 and 2006 accident years. The casualty and other lines favorable development of $87.4 million reflects the net result of releases of $121.4 million primarily in the US and non-US casualty portfolios, partially offset by net adverse development of $13.0 million associated with the results of an external review of the Company’s asbestos and environmental reserves and $21.0 million related to a commutation of a stop loss reinsurance agreement.
During 2006, the Company had net favorable prior year reserve development in property and casualty operations of $110.6 million. Within the Insurance segment, net overall favorable prior year reserve development for the year ended December 31, 2006, was $13.2 million. This overall favorable development included reserve releases of $94.4 million in property lines and $91.1 million in casualty lines, partially offset by $96.5 million, $46.5 million and $29.3 million of prior year adverse development in certain professional, marine, and other lines of business, respectively. Within the Reinsurance segment, net overall favorable prior year reserve development for the year ended December 31, 2006 was $97.4 million. This overall favorable development was made up of releases of $133.0 million in property and other shorter-tail lines of business and partially offset by prior year adverse reserve development of $7.3 million in casualty and other lines and $28.3 million within structured indemnity lines. The overall net favorable development within property and other short-tail lines of $133.0 million included $75.4 million in adverse development specifically related to the 2005 catastrophes.
4. Reduction in insured losses from natural catastrophes during 2007 and 2006 as compared to
5. The Company’s growing average investment asset base and higher net investment income
The Company’s ability to underwrite business is largely dependent upon the quality of its claims paying and financial strength ratings as evaluated by independent rating agencies. As a result, in the event that the Company’s financial strength rating is downgraded, its ability to write business may be adversely affected. In January 2008, A.M. Best Company, Inc. (“A.M. Best”) revised the financial strength rating of the Company’s leading property and casualty operating subsidiaries to “A” from “A+” and affirmed them with a ‘stable’ outlook. The downgrade by A.M. Best was primarily due to their concerns regarding the Company’s historic earnings volatility. In addition, both Fitch and Moody’s downgraded the financial strength rating of the Company’s leading property and casualty operating subsidiaries to “A+” from “AA-” and to “A1” from “A3”, respectively.
The Company has continued to work closely with the various rating agencies in late 2007 and early 2008 in order to manage and evaluate its capital needs to support the volume of business written in order to maintain its claims paying and financial strength ratings. The Company continues to address these needs by monitoring various risk management measures and implementing capital structuring initiatives intended to reduce volatility while, at the same time, improve the quality of the Company’s risk adjusted returns. Such risk management measures and capital structuring initiatives in 2007 and 2006 have included several key business initiatives such as reinsurance structures as well as debt and capital transactions. Details of these transactions are further described below in the Liquidity and Capital Resources section of this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
In addition, in connection with its refined strategy, the Company completed the secondary public offering of 10,627,422 SCA common shares previously held by XL Insurance (Bermuda) Ltd and received proceeds, net of offering costs, of approximately $316.3 million and thereby reduced its ownership of SCA’s outstanding common shares from approximately 63% to approximately 46%. Subsequent to the effective date of sale, June 6, 2007, SCA was no longer a consolidated subsidiary or operating segment of the Company and its remaining investment in SCA was accounted for using the equity method of accounting.
In addition to the evaluation of the impact of the credit and sub prime markets on the Company’s investment portfolio and financial guarantee exposures, as discussed above, management has also completed detailed assessments of the exposure
The Company has a portfolio that is highly diversified by product and geographical region including growing European, Design, Select and Private Commercial portfolios. Total gross professional lines premiums written for 2007 were $1.5 billion. The average policy limit for the Company’s public D&O portfolio is approximately $12 million, with higher average limits written in Bermuda and Europe and lower average limits in the United States. The Side-A only component of the Company’s public D&O portfolio is significant, representing approximately one-third of the gross premiums written in 2007 and approximately 45% by policy limit.
The Company has considered all filed notices through year-end 2007, as well as potential further notice activity that it believes could arise from insureds that have been linked to sub-prime related matters in establishing the unpaid loss and loss expenses as at December 31, 2007.
In addition, clash events are considered by management in the underwriting, risk management and loss ratio selections. Specifically, with respect to financial institution exposures, the Company manages risk through limited line sizes, higher attachment points, risk-adjusted rate levels and increased use of Side-A policies. Furthermore, the 2007 professional lines reinsurance structure takes into account clash events, with $270 million of coverage available in the $35 million excess of $15 million layer. The 2008 reinsurance program has renewed in January 2008 on substantially the same basis as 2007.
As an insurer, the Company must ensure that it has sufficient funds to settle claims promptly, especially upon the occurrence of a major catastrophic event or respond to other unscheduled signficant liquidity needs. Management is focused on making sure that liquidity requirements are supported by having lines of credit facilities available to the Company as well as by the Company’s general investment portfolio, the majority of which is invested in high grade fixed income securities. The Company has had positive cash flow from operations in the three years ended December 31, 2007 generated from its underwriting activities (premiums less claim and expense settlements) as well as the receipt of investment income on its portfolio. The Company expects cash flow from operations to be positive in 2008.
As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with GICs which were correspondingly matched with invested assets. XLCA provided financial guarantee insurance policies insuring timely payment of GICs issued by XLAF. Based on the terms and conditions of the underlying GICs, upon downgrades of XLCA below certain ratings levels, all or portions of outstanding principal balances on such GICs would come due. In January and February 2008, several rating agencies downgraded SCA and its subsidiaries
and as a result, the Company will settle, by late March 2008, the majority of the GIC portfolio. Management had prepared for this possibility and does not expect this liquidity need to have any significant negative impact on the Company’s financial position or results of operations.
Another important matter on which management is focused (and which also affects the Company’s ability to underwrite business) is the availability of collateral. Collateral includes letters of credit, insurance trusts and other credit facilities required to provide security to cedants (which are companies who reinsure their liabilities to the Company), particularly as required by state insurance regulation in the U.S. and at Lloyd’s, and also to provide the Company with liquidity as required. These facilities are provided to the Company from commercial banks. The Company’s principal credit facilities have tenors of two, three, and five years. The Company has also utilized “off balance sheet” transactions in order to obtain more collateral capacity (these transactions are described below under “Variable Interest Entities and Other Off- Balance Sheet Arrangements”). As the Company writes more business, its collateral requirements will increase. A key challenge for management is to ensure that sufficient collateral capacity is available to support future writing of business.
In late October 2007, the Company announced that Mr. Brian M. O’Hara, President and Chief Executive Officer (“CEO”) of the Company, had informed the Company’s Board of Directors of his decision to retire as President and CEO in mid-2008. Accordingly, the Board of Directors implemented a CEO succession plan including the authorization of a Succession Committee to lead the new CEO selection process. On December 28, 2007, Mr. Michael P. Esposito Jr., then Chairman of the Board, resigned from the Company and on the same day, Mr. O’Hara was appointed as Acting Chairman of the Board.
On January 7, 2008, the Company announced that Clive R. Tobin will retire effective April 1, 2008 from the role of Chief Executive of the Company’s Insurance Operations, and will concentrate on assisting XL with strategic opportunities in emerging markets. David B. Duclos, currently Chief Operating Officer of the Company’s Insurance Operations, will succeed Mr. Tobin as Chief Executive of the Company’s Insurance Operations.
In September 2007, Ms. Kirstin Romann Gould was appointed to the role of General Counsel of the Company which also includes her prior responsibilities as General Counsel, Corporate Affairs and Corporate Secretary.
With respect to the Company’s insurance operations, the Company is notified of insured losses and records a case reserve for the estimated amount of the settlement, if any. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of legal counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. With respect to the Company’s reinsurance 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. The uncertainty in the reserving process for reinsurers is due, in part, to the time lags inherent in reporting from the original claimant to the primary insurer to the reinsurer. As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, the Company is subject to a potential additional time lag in the receipt of information as the primary insurer reports to the broker who in turn reports to the Company. As of December 31, 2007, the Company did not have any significant back-log related to its processing of assumed reinsurance information.
IBNR reserves are estimated by the Company’s actuaries using several standard actuarial methodologies including the loss ratio method, the loss development or chain ladder method, the Bornhuetter-Ferguson (“BF”) method and frequency and severity approaches. IBNR related to a specific event may be based on the Company’s estimated exposure to an industry loss and may include the use of catastrophe modeling software. On a quarterly basis, IBNR reserves are reviewed by the Company’s actuaries, and are adjusted as new information
The pattern of loss emergence is determined using actuarial analysis, including judgment, and is based on the historical patterns of the recording of paid and reported losses by the Company, 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 general 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 fall between the property and casualty insurance. For reinsurance business, loss reporting lags the corresponding insurance classes by at least one quarter due to the need for loss information to flow from the ceding companies to the Company generally via reinsurance intermediaries. Such lags in loss reporting are reflected in the actuary’s selections of loss reporting patterns used in establishing the Company’s reserves.
The Company’s three types of property and casualty reserve exposure with the longest tails are:
In the Company’s 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 Company’s estimated ultimate cost of a loss.
Except for certain workers’ compensation liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation unpaid losses that are considered fixed and determinable. For further discussion see the Consolidated Financial Statements.
The Company’s net unpaid losses and losses expenses (excluding financial guarantee reserves related to reinsurance agreements with SCA that are recorded within “Net loss from operating affiliates”) relating to the Company’s operating segments at December 31, 2007 and 2006 was as follows:
During 2007, the Company undertook a review of its methodology for calculating reserve ranges around its single point reserve estimate. The Company modeled a statistical distribution of potential reserve outcomes over a one year run-off period for each of the approximately 50 lines of business. In doing so the Company evaluated a number of alternative models, and for each line of business the Company’s actuaries selected the one 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. In addition, the Company commissioned an external review of its methodology which also included an independent assessment of potential reserve volatility. The Company used the modeled statistical distribution to calculate an 80% confidence interval for the potential reserve outcomes over this one year run-off period. The high and low end points of the ranges set forth in the above table are such that there is a 10% modeled probability that the reserve will develop higher than the high point and a 10% modeled probability that the reserve will develop lower than the low point. The results of the external review noted above are consistent with the one year run-off reserves ranges developed by the Company.
Reserve volatility was analyzed for each line of business (excluding structured indemnity) within each of the Reinsurance and Insurance segments’ using the Company’s historical data supplemented by industry data. These ranges were then aggregated to the lines of business shown above taking into account correlation between lines of business. The practical result of the correlation approach to aggregation is that the ranges by line of business disclosed above, are narrower than the sum of the ranges of the individual lines of business. Similarly, the range for the Company’s total reserves in the aggregate, is narrower than the sum of the ranges for the lines of business disclosed above.
During 2006, the Company reviewed the correlation assumptions between its various lines of business. There was growth in certain lines of business as well as changes in the groupings of the data used in the reserving process. These changes necessitated a review of the correlation matrix used to develop the Company’s reserve ranges. The Company took a simplified approach of assigning ratings of low, medium or high to its correlation assumptions for each line of business pairing based on the judgment of the reserving actuaries, as there was both limited historical experience within its portfolio and limited applicable industry data. However, the Company’s actual historical experience and industry data were used to judgmentally select a range of values for the low, medium and high correlations, respectively, of 15%, 30% and 50%. It should be noted that both the Company’s own experience and the industry data exhibit negative correlations in reserve developments between certain lines of business. However, as a measure of prudence in evaluating the reserve ranges, the Company has used a minimum of 15% correlation between any two lines of business. The analysis of correlations and the reflection of potential diversification benefits across lines of business represent another area of uncertainty in the development of estimated reserve ranges.
The financial guarantees that the Company reinsures or otherwise guarantees relate almost exclusively to transactions with SCA which reinsure scheduled payments of principal and interest due on various types of financial obligations against payment default by the issuers of such obligations. Management establishes reserves for losses and loss adjustment expenses on such business based on management’s best estimate of the ultimate expected incurred losses. The Company’s estimated ultimate expected incurred losses are comprised of:
(i) case basis reserves, (ii) unallocated reserves, and (iii) cumulative paid losses to date. Establishment of such reserves requires the use and exercise of significant judgment by management, including with respect to estimates regarding the occurrence and amount of a loss on an insured obligation. Estimates of losses may differ from actual results and such difference may be material, due to the fact that the ultimate dispositions of claims are subject to the outcome of events that have not yet occurred. Examples of these events include changes in the level of interest rates, credit deterioration of insured obligations, and changes in the value of specific assets supporting insured obligations. Both qualitative and quantitative factors are used in establishing such reserves. In determining the reserves, management considers all factors in the aggregate, and does not attribute the reserve provisions or any portion thereof to any specific factor.
In addition to case basis reserves, the Company maintains an unallocated loss reserve for expected losses inherent in the Company’s in-force business (consisting of both financial guarantee insurance and reinsurance business) that is expected to emerge in the future. The unallocated loss reserves are reported to the Company by SCA as the cedant and represent the Company’s estimated ultimate liability from claims expected to be incurred in the future under in-force insured and reinsured policies less outstanding case basis reserves and cumulative paid claims to date on such policies.
The Company updates estimates of losses and loss adjustment expense reserves quarterly and any resulting changes in reserves are recorded as a charge or credit to earnings in the period such estimates are changed.
financial guarantee industry with regard to the methodology and measurement of such reserves. While management believes that the principles it applies are the most appropriate for its business and have applied them consistently within the periods presented, alternate methods may produce different estimates as compared to the current methodology currently used. Accounting practices in the financial guarantee insurance and reinsurance industry are currently being reviewed by applicable regulatory bodies and any changes required by that review could have a material effect on the reported operating results and financial condition of the industry or particular market participants, including the Company, depending on the extent to which current policies differ from those promulgated by such regulatory bodies.
The Company’s risk management department is responsible for monitoring the performance of the in-force portfolio through coordination with SCA’s surveillance system. They maintain a list of credits that they have determined need to be closely monitored and, for certain of those credits, the SCA surveillance team undertake remediation activities they determine to be appropriate in order to mitigate the likelihood and/or amount of any loss that the Company could incur with respect to such credits.
Claims and expenses for individual policies within these annuity reinsurance contracts are projected over the lifetime of the contract to calculate a net present value of future cash flows. Assumptions for each element of the basis (mortality, expenses and interest) are determined at the issue of the contract and these assumptions are locked-in throughout the term of the contract unless a premium deficiency exists. The assumptions are best estimate assumptions plus provisions for adverse deviations on the key risk elements (i.e., mortality and interest). Provisions for adverse deviation are designed to cover reasonable deviations from the best estimate outcome of the contract. As the experience on the contracts emerges, the assumptions are reviewed. This occurs at least annually and includes both an analysis of experience and review of likely future experience. If such review would produce reserves in excess of those currently held then lock-in assumptions will be revised and a loss recognized. During the years ended December 31, 2007, 2006 and 2005, there were no adjustments to the locked-in assumptions for these contracts.
The Company also provides reinsurance of disability income protection, for an in-force block of business. The future policy benefit reserves for these contracts amounted to approximately $90 million and $79 million at December 31, 2007 and 2006, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience. The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide an income if the policyholder becomes sick or disabled. The liabilities are therefore driven mainly by the rates at which policyholders become sick (where sickness is defined by the policy conditions) and by the rates at which these policyholders recover or die. A 1% increase in the incidence rate would increase the value of future claims by approximately $0.6 million, while a 1% decrease in the termination rate would increase the value of future claims by approximately $0.7 million. Following a review of claim termination experience, the reserving assumptions were revised during 2007. The overall effect of the revised assumptions was a reduction in income of $10.0 million. No changes to the locked-in assumptions were made in 2006.
The Company also provided reinsurance of a block of U.S. based term assurance, which was novated to the Company from an insurance affiliate in December 2002. The future policy benefit reserves for these contracts amounted to approximately $245 million and $204 million at December 31, 2007 and 2006, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience.
During 2006, the Company also began to provide reinsurance of U.S. based term assurance derived from new business written by client companies. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of assumptions at inception with periodic review against experience. As at December 31, 2007, the benefit reserves for these contracts were immaterial.
The Company’s deposit liabilities at December 31, 2007 reflect obligations assumed under funding agreements, municipal guaranteed reinvestment contracts, payment undertaking agreements and certain structured insurance and reinsurance agreements. For each of these contracts, the Company establishes a deposit liability equal to the net cash received at inception. Each deposit liability accrues at a rate equal to the internal rate of return of the payment receipts and obligations due during the life of the agreement. Where the timing and/or amount of future payments are uncertain, cash flows reflecting the Company’s actuarially determined best estimates are utilized. The ultimate size of underlying losses, the impact of the contractual limits upon settlement of such losses, and the impact of the underlying loss settlement process on the timing of payments are considered as appropriate. Where uncertainty is present, an increase in the ultimate claims cost or accelerated claims settlement would potentially lead to an increase in the deposit liability accretion rate or lead to incurred losses if significant. The interest expense reported due to the accretion of deposit liabilities associated with structured insurance and reinsurance contracts was $76.6 million, $37.8 million and $49.8 million for the years ended December 31, 2007, 2006 and 2005, respectively. For some of the Company’s deposit liabilities, the accretion rate is recorded at its contractual maximum level. For all other contracts, a 1% increase in the average accretion rate would result in an increase in deposit liabilities and interest expense by $25.5 million on an annualized basis. See Item 8, Note 12 to the Consolidated Financial Statements, “Deposit Liabilities.”
The Company conducts activities in three main types of derivative instruments: investment-related derivative instruments, embedded credit derivatives related to financial guarantee reinsurance agreements and weather and energy derivatives. The estimate of fair value for credit derivatives and weather and energy derivatives requires management’s judgment. These two activities are discussed below:
The Company is exposed to certain credit derivatives in connection with its financial guarantee reinsurance of subsidiaries of SCA. In determining fair value, the Company relies primarily on reported mark-to-market adjustments from SCA as well as its own analysis of the related exposures. The Company reviews the SCA methodology and its application. SCA’s estimate of the fair value of its in-force CDS contracts is based on the use of valuation techniques involving management judgment in regard to a number of factors, including:
the actual amount of subordination in the CDS contracts before liability attaches;
credit price indices, published by non-affiliated financial institutions, for the type(s) of assets;
referenced in the CDS contracts (both in terms of type of assets and their credit rating);
price discovery resulting from discussions and negotiations with market participants to commute or transfer the risks in any of the CDS contracts; and
The weight ascribed to these factors in forming the best estimate of the fair value of SCA’s CDS contracts may vary under changing circumstances. In periods prior to the quarter ended September 30, 2007, SCA principally considered price indices published by nonaffiliated financial institutions in forming the best estimate of the fair value of the CDS contracts. The fair value of the guarantee was determined by multiplying the percentage change in the applicable credit price index or indices applicable to the assets referenced in the CDS by the present value of the remaining expected future premiums to be received under the contract.
in substantially all other instances the estimate of the fair value of CDS contracts ascribed significant weight to judgments regarding rates of return required by market participants in the current market environment and the amount of subordination required by market participants before their liability would attach under the CDS contracts. The estimated fair value was calculated by adding any additional subordination, if required based on SCA’s ratings or that of the rating agencies, to the amount of additional premium required to be paid to transfer the risk to achieve the selected rate of return. Such premium was calculated by adjusting the present value of the expected remaining future net cash flows under such contracts (which are comprised of the remaining expected future premiums to be received under the contract, less estimated maintenance expenses and a provision for expected losses that will manifest in the future) to reflect the best estimate of the rates of return that would be required by a counterparty to assume the risks on such contracts.
Changes in fair value are unrealized as the credit derivatives are not traded to realize this value. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis and Item 8, Note 15 to the Consolidated Financial Statements, “Derivative Instruments.”
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These primary factors include (i) the time period during which there has been a significant decline in value, (ii) an analysis of the liquidity, business prospects and financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question, (v) expected future interest rate movements, and (vi) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. In addition, EITF 99-20 requires that other-than-temporary impairments for certain asset backed and mortgage backed securities are recognized if the fair value of the security is less than its cost or amortized cost 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
For further information see “- Other Revenues and Expenses” and Item 8, Note 24 to the Consolidated Financial Statements, “Taxation.”
Intangible assets are carried at or below estimated fair value. There are many assumptions and estimates underlying the fair value calculation. Principally, the Company identifies the business entity that the intangible asset is attributed to, and reviews historical and forecasted performance and other underlying factors affecting such analysis, including market conditions, premium rates and loss trends. Other assumptions used could produce a significantly different result which may result in a change in the value of the intangible asset and related amortization charge in the Consolidated Statement of Income. Based on the current expectations of profitability, an impairment charge would only be recognized in the event of a significant decline in the expected profitability of those operations where such intangible assets are applicable. At December 31, 2007, intangible assets were $1.8 billion of which approximately $1.4 billion and $0.4 billion related to the Company’s Reinsurance and Insurance segments, respectively. See “Other Revenue and Expenses” for further information.
On proportional contracts, written premiums are estimated to expected ultimate premiums based on information provided by the ceding companies. An estimate of premium is recorded at the inception of the contract. The ceding company’s premium estimate may be adjusted based on their history of providing accurate premium estimates. When the actual premium is reported by the ceding company, normally on a quarterly basis, it may be materially higher or lower than the estimate. Adjustments arising from the reporting of actual premium by the ceding companies are recorded in the period in which they are determined.
The amount of proportional and excess of loss reinsurance gross premiums written and gross acquisition expenses recognized by the Company’s reinsurance operations for each line of business for the years ended December 31, 2007, 2006 and 2005 was as follows:
Gross premiums written decreased by 3.4% during the year ended December 31, 2007 compared with the year ended 2006, while net premiums written increased slightly during the same period. Decreases in gross premiums written were due primarily to a combination of a decrease in rates, reduced shares and selective non-renewals in certain property and marine lines of business, as well as the runoff of certain property catastrophe exposures. Partially offsetting these decreases was growth in the excess and surplus book of business in the U.S., increases in the number of long-term agreements, strong new business and higher renewal retentions within certain casualty lines of business, and favorable foreign exchange rate movements. Net premiums written increased slightly as the reduction in ceded premiums written was mostly offset by the reduction in gross premiums written noted above. Ceded premiums written decreased as a result of favorable outward reinsurance pricing conditions, increased retention related to certain captive programs and marine and energy treaties, as well as refunds associated with property catastrophe programs. Partially offsetting the decrease in ceded premiums was the impact of return premium associated with the commutation of ceded reinsurance policies in professional lines of business in 2006.
Gross and net premiums written decreased by 3.8% and 2.9%, respectively, in the year ended December 31, 2006 compared with the year ended December 31, 2005. The decrease in gross premiums written was primarily due to continued competitive pressures across most non-catastrophe exposed lines, corporate risk management initiatives to reduce catastrophe exposures, fewer multi-year contracts, and the impact of foreign exchange movements on premium. Decreases in casualty premiums and the discontinuation of the segment’s surety business were partially offset by volume increases in certain specialty lines of business such as environmental and aerospace. The decrease in net premiums written was primarily a result of the factors impacting gross premiums written, partially offset by return premium associated with the commutation of ceded reinsurance policies in professional lines of business, the cancellation of certain property catastrophe reinsurance programs and the absence of catastrophe related ceded reinstatement premiums.
The loss ratio for the Insurance segment for the year ended December 31, 2007 decreased compared with the year ended December 31, 2006, primarily due to net favorable prior year development in 2007 being greater than the net favorable prior year development in 2006. The Insurance segment net prior year reserve releases consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively. Casualty releases relate primarily to the European casualty portfolio in accident years 2002-2005. The professional lines development reflects net adverse prior year development of the Bermuda E&O portfolio and releases from the Hartford and European professional lines portfolios. Strengthening in other insurance lines relates to adverse development in discontinued specialty lines, surety and environmental, partially offset by favorable development in aerospace and political risk. Gross prior year development was also favorable at $177.6 million. Excluding prior year development in both years, the loss ratio increased by 1.0 points partly due to an increase in attritional and catastrophe-related property experience and partly due to softening market conditions primarily in certain specialty lines.
There is no assurance that conditions and trends that have affected the development of liabilities in the past will continue. Accordingly, it is not appropriate to extrapolate future redundancies or deficiencies based on the Company’s historical results.
The underwriting expense ratio in the year ended December 31, 2006 increased compared to the same period in 2005, as a result of an increase in the operating expense ratio of 2.9 points (15.4 % as compared to 12.5%) partially offset by a lower acquisition expense ratio. The increase in the operating expense ratio was due primarily to increased performance-based compensation costs. The lower acquisition expense ratio related primarily to a reduction in certain ceded brokerage costs in 2006 combined with the impact on the expense ratio of reinstatement premiums earned in 2005.
Certain lines of business previously reported under the Financial Lines segment have been reclassified and reported under the Insurance and Reinsurance segments based on the nature of the business written.
Gross and net premiums written decreased 9.1% and 12.8%, respectively, in the year ended December 31, 2006 as compared to year ended December 31, 2005. The decrease in gross and net premiums written was primarily attributable to rate and volume reductions within the casualty line of business, and catastrophe gross and net reinstatement premiums of $138.7 million and $34.7
Net premiums earned in the year ended December 31, 2007 decreased 10.5% as compared to the same period in 2006. Net premiums earned in the year ended December 31, 2006 decreased 6.0% as compared to the year ended December 31, 2005. The decrease in both 2007 and 2006 was a reflection of the overall reduction of net premiums written over the last three years.
The decrease in the loss and loss expense ratio for the Reinsurance segment in the year ended December 31, 2007, compared to the same period in 2006, is due primarily to net favorable prior year loss development. Within the Reinsurance segment, reserve releases of $188.7 million primarily in property and other short-tail lines of business and $87.4 million in casualty and other lines, was partially offset by adverse prior year development of $8.8 million within the structured indemnity line of business. Releases in the short-tail lines relate primarily to the 2005 and 2006 accident years. The casualty and other lines favorable development of $87.4 million reflects the net result of releases of $121.4 million primarily in the US and non-US casualty portfolios, partially offset by net adverse development of $13.0 million associated with the results of an external review of the Company’s asbestos and environmental reserves and $21.0 million related to a commutation of a stop loss reinsurance agreement. Excluding prior year development, the loss ratio for the year ended December 31, 2007 increased by 5.1 loss percentage points as compared to the same period in 2006 as a result of higher attritional losses within the property risk book of business as well as losses recorded relating to certain catastrophe losses including European windstorms Kyrill and Per/Hanno, California wildfires and the Peru earthquake. Favorable gross prior year development of $259.7 million was in line with the net development.
during 2005. In the year ended 2006, net favorable prior year development of $97.4 million resulted primarily from net favorable development in property and other short-tail lines of $133.0 million including adverse development on the loss estimates for the 2005 catastrophes of $74.6 million. In addition, casualty lines reflected reserve releases of $10.9 million while structured indemnity and other lines of business resulted in net adverse reserve development of $28.3 million and $18.2 million, respectively. The gross prior year favorable development for the Reinsurance segment was $17.7 million. This gross favorable development was less than the corresponding net development as net adverse development on the 2005 catastrophes was less significant than the gross adverse development due to reinsurance recoveries.
The increase in the loss and loss expense ratio in the year ended December 31, 2005 primarily reflected the effects of Hurricanes Katrina, Rita and Wilma combined with the Other Cats from which the Reinsurance segment incurred a combined $977.9 million of net losses. In addition, during 2005, net prior year reserves across the Reinsurance segment developed adversely by $93.5 million and included net adverse development of $266.9 million in casualty and professional lines was partially offset by releases in short-tail lines of business of $173.4 million.
The increase in the underwriting expense ratio in year ended December 31, 2006, compared to the same period in 2005, was due to an increase in the operating expense ratio to 7.4%, as compared to 5.5% in the year ended December 31, 2006. The operating expense ratio increase was primarily due to an increase in performance-based compensation expenses and costs related to various strategic initiatives within the Reinsurance segment including the establishment of an integrated reinsurance platform in Europe. The increase in operating expenses was offset by a decrease in the acquisition expense ratio from 21.3% during the year ended December 31, 2005 to 19.9% in the same period in 2006. The decrease in the net acquisition expense ratio was due primarily to commissions received from Cyrus Re related to the property catastrophe retrocession.
Net results from structured reinsurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Results from these products for the year ended December 31, 2007 decreased compared to the same period in 2006 mainly as a result of a higher accretion rate recorded in 2007 on deposit liabilities relating to certain workers’ compensation coverage and partially offset by higher net investment income in 2007 as a result of an increase in the average size of investment asset balances as a result of new transactions. Net results from structured reinsurance products for the year ended December 31, 2006 increased compared to the same period in 2005 primarily as a results of higher net investment income from new transactions and a reduction in interest expense accretion in 2006 relating to certain deposit liabilities resulting from a change in the timing of estimated cash flows.
The following table is an analysis of the Life operations gross premiums written, net premiums written and net premiums earned for the last three years ended December 31:
1. Second quarter of 2007 - one Irish immediate annuity portfolio bound, for which net premium earned totaled $94.6 million.
Gross premiums written relating to other life business increased by $98.9 million or 29.4% in the year ended December 31, 2007 as compared to the year ended December 31, 2006 primarily as a result of growth in the underlying book of term assurance and critical illness business of $79.6 million, combined with favorable foreign exchange movements of $19.3 million. Gross premiums written relating to annuity business decreased by $42.6 million or 12.2% in the year ended December 31, 2007 as compared to the year ended 2006 mainly due to a lower level of single premium annuity portfolio business of $57.8 million, offset by favorable foreign exchange rate movements of $15.2 million. Ceded premium ratios remained roughly consistent with the prior year. Gross premiums written relating to other life business increased by $74.8 million or 28.6% in the year ended December 31, 2006 as compared to the year ended December 31, 2005 primarily due to growth in the underlying book of term assurance and critical illness business of $57.6 million, growth in the underlying book of short-term accident and health business of $11.2 million, and favorable foreign exchange movements of $6.0 million. Gross premiums written relating to annuity business decreased by $1,738.2 million or 83.2% in the year ended December 31, 2006 as compared to the year ended 2005 mainly as a result of the large U.K. immediate annuity portfolio contract bound in 2005 representing $1,797.3 million of gross premiums written, offset by an increase in Irish immediate annuity portfolio business of $56.3 million and favorable foreign exchange rate movements of $2.8 million. Ceded premium ratios remained roughly consistent with the prior year.
In accordance with U.S. GAAP treatment for life business, a loss recognition test process was carried out in 2007 on a block of U.S.-based term life mortality business, to determine if expected future premiums would be sufficient to pay for expected future losses. This process led to management’s decision to unlock the then current policy benefit reserve basis and record a loss of $25.4 million on this block of business. In 2005, $37.4 million in losses were recorded relating to the same block of business as a result of a similar loss recognition test that was carried out during that year.
Claims and policy benefit reserves decreased significantly in 2006 as compared to 2005 mainly due to the large U.K. immediate annuity contract bound in 2005 as well as losses recorded relating to the novated blocks of U.S.-based term life mortality business noted above.
Acquisition costs increased by 21.8% in 2007 as compared to 2006 mainly as a result of the growth in the book of regular term assurance and critical illness treaties consistent with the earned premium variance, as well as the impact of a favorable profit commission adjustment recorded in 2006 relating to a term life treaty. Operating expenses decreased by 2.5% in 2007 as compared to 2006 primarily as a result of a decrease in both professional fees and corporate allocations, offset by unfavorable foreign exchange rate movements and higher compensation costs.
Acquisition costs decreased by 7.4% in 2006 as compared to 2005, primarily as a result of a $25.9 million write-off of certain deferred costs related to the novated blocks of U.S. mortality business noted above in 2005 and partially offset by a higher volume of regular term assurance and critical illness business in 2006. Operating expenses increased in 2006 as compared to 2005 due to the build out of existing operations and start-up costs of new life operations, including the U.S. life reinsurance platform and the U.K. life fund integration team, as well as an increase in professional fees and corporate allocations related to these initiatives.
The Other Financial Lines segment is comprised of the guaranteed investment contract and funding agreement businesses. For the year ended December 31, 2007, the net results from these structured products were $48.1 million and included net investment income, interest expense and operating expenses of $389.0 million, $326.4 million, and $14.5 million, respectively. For the year ended December 31, 2006, the net results from these structured products were $34.7 million and included net investment income, interest expense and operating expenses of $341.9 million, $296.9 million, and $10.4 million, respectively, while in 2005, the net results from these structured products were $33.7 million and included net investment income, interest expense and operating expenses of $213.3 million, $166.4 million, and $13.2 million, respectively. For 2007, net investment income increased primarily as a result of an increase in yields on invested assets. Interest expense increased due to an increase in the average deposit liability balance combined with an increase in crediting rates consistent with the yield changes noted above. Operating expenses increased by $4.1 million during 2007 as compared to 2006 primarily due to reclassification of certain contract expenses and partially offset by reduced corporate allocations. Consistent with 2007, net investment income increased in 2006 as compared to 2005 as a result of an increase in the average asset balances while interest expense increased during the same period as a result of an increase in the average deposit liability balances.
For the period from January 1 to June 6, 2007, continued growth in net premiums earned from SCA’s financial guarantee business was offset by the absence of significant accelerated refunding premiums in 2007 that were reported in 2006. Net losses and loss expenses decreased mainly due to no significant new case basis provisions in the first five months of 2007 combined with a case reserve release recorded in the first quarter of 2007. Overall net income from SCA, however, decreased as net realized and unrealized losses related to outstanding credit derivatives increased significantly as market spreads widened during the first five months of 2007 which was partially offset by a decrease in realized investment losses associated with an impairment charge recorded in the first nine
For the year ended 2006 as compared to the year ended 2005, net income from SCA increased by 28.6% to $104.6 million from $81.3 million, respectively, primarily as a result of an increase in net premiums earned, lower net losses and loss expenses and higher net investment income. Net premiums earned increased in 2006, as compared to 2005, as a result of growth of the in-force business (in particular, installment premium business written in prior periods) and earned premiums from the early retirement or refunding of insured securities. In addition, net losses and loss expenses for the year ended December 31, 2006, decreased compared to the same period in 2005 as a result of lower case basis reserves recorded in 2006 as compared to 2005, while net investment income increased in the same period due to increases in the investment asset balances in 2006.
For a summary of realized and unrealized gains and losses on all derivative instruments, see Item 8, Note 15 to the Consolidated Financial Statements, “Derivative Instruments.”
Net investment income related to property and casualty operations increased in 2006 as compared to 2005 due primarily to increases in the yield of the portfolio and a higher investment base. The market yield to maturity on the fixed income portfolio was 5.2% at December 31, 2006, as compared to 4.7% at December 31, 2005, due primarily to higher interest rates in the U.S., U.K., and Euro-zone. The growth in the investment base reflected the Company’s issuance of ordinary shares and equity units in the fourth quarter of 2005 and the Company’s positive cash flow from operations.
The Company expects stable net investment income from its property and casualty operations in 2008, The average asset base and yields are both expected to be stable relative to current levels. For a further discussion see “Liquidity and Capital Resources.”
Portfolio returns are calculated by dividing the sum of the net investment income or net income from investment fund affiliates, realized gains (losses) and unrealized gains (losses) by the average market value of each portfolio. Performance is measured in either the underlying asset currency or the functional currency.
In 2007, net realized losses on investments were $603.3 million which included $1,012.8 million of gross realized losses on fixed income and $46.9 million of gross realized losses on equity securities. Gross realized losses in 2007 included $611.0 million of provisions for declines in fair value considered to be other than temporary. Included in the balances noted below are realized losses and impairment in the sub-prime and related mortgage exposed portfolios totaling $385.1 million. As a percentage of the total fixed income portfolio, the write-down for other than temporary declines was 1.5% in 2007 as compared to 0.3% in 2006 and 0.1% in 2005. Further details are included in “Results of Operations”.
In the U.S., the general level of corporate defaults was lower than in recent years. For example, Moody’s Investors Service, Inc. (“Moody’s”) reported that 12 issuers defaulted in 2007 compared with 23 issuers in 2006 and 30 issuers in 2005. The Company’s exposure to these corporate defaults was limited in both 2007 and 2006, resulting in a low level in the write-down for other than temporary declines related to corporate credit events.
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors, as discussed under “Critical Accounting Policies and Estimates.”
The Company records the income related to certain operating affiliates on a three month lag in order for the Company to meet accelerated filing deadlines.
Net losses from financial operating affiliates in 2007 include the results and related write-downs associated with SCA and Primus as well as the impact of losses recorded on reinsurance transactions with SCA of approximately $351.0 million. Further details are included in “Results of Operations”. In addition, see Notes 3 and 8 to the Consolidated Financial Statements, “Security Capital Assurance” and “Investments in Affiliates”, for further information.
Amortization of intangible assets decreased in 2007 as a result of certain intangible assets that were fully amortized during 2006.
Corporate operating expenses decreased by 30.2% in 2007 as compared to 2006 primarily as a result of certain compensation costs being allocated to the operating segments in 2007. Corporate operating expenses increased by 7.4% in 2006 as compared to 2005 primarily as a result of increased performance-based compensation costs and increased legal costs.
Interest expense from property and casualty operations includes costs related to the Company’s debt and collateral facilities as well as certain deposit liability accretion. Interest expense was higher in 2007 as compared to 2006 primarily due to the issuance of the 2027 Senior Notes in early May 2007 as well as the costs associated with the retirement of the 2009 Senior Notes. The increase in interest expense in 2006 as compared to 2005 primarily reflected the increase in average outstanding debt. For more information on the Company’s financial structure, see “Liquidity and Capital Resources.”
The deferral of tax losses is evaluated based upon the future profitability of the Company’s taxable entities and, under current projections, the Company anticipates using this asset. The Company’s net deferred tax asset at December 31, 2007 was $370.4 million, which consisted primarily of net operating losses generated by subsidiaries in the U.K. Should the taxable income of these entities fall below expectations, a further valuation allowance may have to be established, which could be significant. In addition, if any further losses are generated by these entities, these losses may not be tax effected. See “Critical Accounting Policies and Estimates” and Item 8, Note 24 to the Consolidated Financial Statements, “Taxation.”
At December 31, 2007 and 2006, total investments, cash and cash equivalents, accrued investment income and net payable for investments purchased were $43.7 billion and $44.7 billion, respectively. The following table summarizes the composition of the Company’s invested assets at December 31, 2007 and 2006:
Of the gross unrealized investment losses on the fixed income and short term investments portfolio at December 31, 2007 of $1,069.5 million, approximately $546.1 million related to corporate fixed income securities. Within the corporate fixed income securities, approximately 68.0% of the losses were in the financial sector, 4.2% in the consumer non-cyclical sector and 4.0% in the industrial sector. No other sector was greater than 4%. The largest unrealized loss in the fixed income portfolio was $7.9 million.
Of the gross unrealized investment losses on the fixed income portfolio at December 31, 2006 of $244.1 million, approximately $122.5 million related to corporate fixed income securities. Within the corporate fixed income securities, approximately 52.9% of the losses were in the financial sector, 11.9% in the communications sector, 8.8% in the consumer non-cyclical sector, 5.4% in the utilities sector and 5.1% in the industrial sector. No other sector was greater than 5%. The largest unrealized loss in the fixed income portfolio was $1.8 million.
No equity securities held by the Company at December 31, 2006 were in a continual unrealized loss position for 12 months. The largest individual unrealized loss in the equity portfolio was $0.5 million.
The table below represents a reconciliation of the Company’s unpaid losses and loss expenses for the year ended December 31, 2007:
The net income impact of losses incurred with respect reinsurance provided to SCA subsequent to the secondary sales of SCA shares on June 6, 2007 of $351.0 million is included in “net loss from operating affiliates”, and the unpaid case reserves related to such losses are in unpaid losses and loss expenses. These losses are associated with credit enhancement of certain ABS CDO exposures as well as residential mortgage backed securities backed by home equity lines of credit collateral. Certain of these underlying exposures were written by SCA in derivative form as credit default swaps. Consistent with both the Company’s and SCA’s accounting policies the unrealized fair value liability on those contracts written in derivative form include both an insurance reserve component and a mark to market liability. A component of the overall fair value liability is classified as a case reserve once the loss in considered probable and can be reasonably estimated. Such case reserves are reported on a discounted basis and net of the present value of related future premiums. The remainder of the liability is classified as a derivative liability.
While the Company reviews the adequacy of established reserves for unpaid losses and loss expenses regularly, no assurance can be given that actual claims made and payments related thereto will not be in excess of the amounts reserved. In the future, if such reserves develop adversely, such deficiency would have a negative impact on future results of operations. See Item 1, “Unpaid Losses and Loss Expenses”, “Critical Accounting Policies and Estimates” and Item 8, Note 10 to the Consolidated Financial Statements, “Losses and Loss Expenses”, for further discussion.
Unpaid losses and loss expense recoverables were $4.7 billion and $5.0 billion at December 31, 2007, and 2006, respectively. At December 31, 2007 and 2006, reinsurance balances receivable were $0.9 and $1.1 billion, respectively. The table below presents the Company’s net reinsurance recoverable at December 31, 2007 and 2006.
Approximately 78% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (excluding collateral held) outstanding at December 31, 2007, were due from reinsurers rated “A” or better by S&P. The following is an analysis of the total recoverable and reinsurance balances receivable at December 31, 2007, by reinsurers owing more than 3% of such total:
Liquidity is a measure of a company’s ability to generate cash flows sufficient to meet short-term and long-term cash requirements of its business operations.
See Item 8 - “Consolidated Statement of Cash Flows.” There are three main sources of cash flows for the Company - those provided by operations, investing activities and financing activities.
The net receipt of premiums less claims and expenses related to its underwriting activities in its property and casualty operations as well as its Life Operations segment.
Cash flow from operations was $2.2 billion in 2007, as compared to $2.4 billion in 2006. The decrease in 2007 is due primarily to the softening market impacts on premiums and partially offset by increased net investment income.
Total net paid losses were $3.8 billion, $3.9 billion and $2.6 billion in 2007, 2006 and 2005, respectively. Net paid losses in 2007 continued to be impacted by payments on the 2005 catastrophes. Similarly, in 2006, the increase in net paid losses was due to payments for catastrophes that occurred in 2005. Net losses incurred were $3.8 billion, $4.2 billion and $7.4 billion in 2007, 2006 and 2005, respectively. The payout of the Company’s casualty reserves at December 31, 2007, could be as long as a thirty year period. Property claims are generally reported and settled within a much shorter period, usually up to three years.
Generally, positive cash flow from operations and financing activities is invested in the Company’s portfolio, including affiliates or acquisition of subsidiaries. Investing activities in 2007 and 2006, were primarily related to the purchase and sale of portfolio investments. In addition to purchases and sales of the Company’s total investment portfolio, the Company sold a portion of its interest in SCA on June 6, 2007, through a secondary offering for $316.3 million. However, as a result of the sale and subsequent deconsolidation of SCA, investing cash flows were reduced by $110.8 million. In 2006, the Company sold a portion of its interest in SCA through a secondary offering for $104.7 million and its interests in Frontpoint Investment Managers for $66.8 million.
If paid losses accelerated beyond the Company’s ability to fund such paid losses from current operating cash flows or events lead to negative cash flows from financing activities, the Company might need to either liquidate a portion of its investment portfolio or arrange for financing. To further ensure the sufficiency of funds to settle such claims, the Company holds a certain amount of invested assets in cash and short-term investments and maintains available credit facilities. In addition, for certain insurance, reinsurance, or deposit contracts that tend to have relatively large and reasonably predictable cash outflows, the Company attempts to establish dedicated portfolios of assets that are duration-matched with the related liabilities.
In addition to ordinary share capital, the Company depends on external sources of financing to support its underwriting activities in the form of:
The majority of the Company’s principal credit facilities are multi-year transactions that will expire in 2009, 2010 and 2012. The following risks are associated with the Company’s requirement to renew these facilities in future years:
The credit available from banks may be reduced resulting in the Company’s need to pledge its investment portfolio to customers. This could result in a lower investment yield.
The Company may be downgraded by one or more rating agencies which could materially and negatively impact the Company’s business, financial condition, results of operations and/or liquidity.
Continued consolidation within the banking industry may result in the aggregate amount of credit provided to the Company being reduced. The Company attempts to mitigate this risk by identifying and/or selecting additional banks that can participate in the credit facilities upon renewal.
On February 23, 2007, the Board of Directors of the Company approved a share repurchase program that authorized the Company to repurchase up to $1.0 billion of its Class A ordinary shares and included the unused $135.4 million allocated to the share repurchase program authorized by the Board of Directors in January of 2000. Under the program, the Company repurchased and cancelled approximately 13.2 million shares during the first nine months of 2007 and fully utilized the $1.0 billion authorized under the share repurchase program. On September 24, 2007, the Board of Directors of the Company approved a new share repurchase program, authorizing the Company to repurchase up to $500.0 million of its Class A ordinary shares. Repurchases may be made from time to time in the open market or in privately negotiated transactions, and the Company expects that those repurchases will be funded from cash on-hand. The timing and amount of the share repurchases under the program will depend on a variety of factors, including market conditions, legal requirements and other factors. As of December 31, 2007, the Company had repurchased 1.8 million shares for $124.5 million under the new share repurchase program.
In connection with the maturity of the purchase contracts associated with the 6.5% Units, the Company issued 10,799,913 Class A ordinary shares for net proceeds of approximately $823.0 million, a portion of which was used to retire the 2009 Senior Notes.
The following tables present the Company’s debt under outstanding securities and lenders’ commitments as at December 31, 2007:
On March 15, 2007, the Company issued 1,000,000 Fixed/Floating Series E Perpetual Non-Cumulative Preference Ordinary Shares, par value $0.01 each, with liquidation preference US$1,000 per share (the “Series E Preference Shares”). The Company received net proceeds of approximately $983.8 million from the offering. Until April 15, 2017, dividends on the Series E Preference Shares are payable semiannually on a non-cumulative basis, when, as and if declared by the Company’s Board of Directors, on April 15 and October 15 of each year, commencing in 2007, at a fixed rate equal to 6.5% per annum on the liquidation preference. From and after April 15, 2017, dividends on the Series E Preference Shares are payable quarterly on a non-cumulative basis, when, as and if declared by the Company’s Board of Directors, on January 15, April 15, July 15 and October 15 of each year at a floating rate equal to three-month LIBOR plus 2.4575% on the liquidation preference. The Series E Preference Shares are perpetual securities with no fixed maturity date and are not convertible into any of the Company’s other securities.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of its foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”), Stoneheath Re (“Stoneheath”). The net effect of these agreements to the Company is the creation of a contingent put option to issue $350.0 million of preference ordinary shares in the aggregate. The agreements provide the Company with a Reinsurance Collateral Account in support of certain Covered Perils named in the Reinsurance Agreement. The initial Covered Perils will include United States wind, European wind, California earthquake and terrorism worldwide. After an initial three-month period, the covered perils as well as the attachment points and aggregate retention amounts may be changed by the Ceding Insurers in their sole discretion. This may result in a material increase or decrease in the likelihood of payment under the Reinsurance Agreement. On each date on which a Ceding Insurer withdraws funds from the Reinsurance Collateral Account, the Company shall issue and deliver to Stoneheath an amount of XL Capital Ltd Series D Preference Shares (the “XL Preferred Securities”) having an aggregate liquidation preference that is equal to the amount of funds so withdrawn from the Collateral Account. The Company is obligated to reimburse Stoneheath for certain fees and ordinary expenses. The initial term of the Reinsurance Agreement will be for the period from the Closing Date through June 30, 2007, with four annual mandatory extensions through June 30, 2011 (unless coverage is exhausted there under prior to such date). The Ceding Insurers may thereafter extend the Reinsurance Agreement at their option for additional calendar quarters without limit (unless coverage is exhausted there under). The contingent put option is recorded at fair value with changes in fair value recognized in earnings. The XL Preferred Securities, if issued, will pay dividends on a non-cumulative basis at a fixed rate of 6.868% per annum through October 15, 2011 and thereafter at a floating rate based on 3-month LIBOR, plus 3.12%.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company. In connection with this transaction, the fair value of the put premiums and other related costs, in total of $109.9 million was charged to “Additional Paid in Capital” and a deferred liability was established (included with “Other liabilities”) of $102.5 million in the Consolidated Balance Sheet at December 31, 2003. The Company amortizes this liability that resulted in an interest expense of approximately $2.3 million in 2007 and $2.6 million in 2006.
At December 31, 2007, the Company had six letter of credit facilities in place with total availability of $7.3 billion, of which $3.7 billion was utilized.
The following letter of credit facilities were originated or renewed during 2007:
On March 22, 2007, the Company amended the $500 million letter of credit facility that originally closed on May 9, 2006, by extending the expiration date to June 22, 2007.
In addition to the letter of credit facilities described above, the Company had the following facility at December 31, 2007 but was subsequently terminated in February 2008:
The following describes certain terms of the documents referred to below. All documents referred to below have been filed with the SEC and should be referred to for an assessment of the complete contractual obligations of the Company.
In December 2007, Standard & Poor’s (“S&P”), affirmed the Company’s core property and casualty operating companies’ financial strength ratings at “A+” with a ‘stable’ outlook. Subsequent the aforementioned fourth quarter 2007 charges, in January 2008, S&P announced it would be taking no rating actions and the Company’s financial strength ratings remained unchanged.
In addition, the Company’s unsecured Lloyd’s letter of credit facility provides that, in the event that the Company’s insurance and reinsurance rated operating subsidiaries in Bermuda fall below a rating of “A-” from A.M. Best, the facility would then be required to be fully secured by the Company, at which time the Company would be required to either (i) provide an amount in cash to cover an amount equal to the aggregate letters of credit outstanding at that time or (ii) deposit assets in trust securing 105% of the aggregate letters of credit outstanding at that time. If this were to occur, the Company may not be able to provide the collateral required in order to maintain this facility.
The following table presents the Company’s long term contractual obligations and related payments as at December 31, 2007, due by period. This table excludes further commitments of $204.7 million to the Company’s related investment funds and certain limited partnerships, and letter of credit facilities of $3.7 billion. See Item 8, Note 15, “Derivative Instruments”, and Note 18, “Commitments and Contingencies”, to the Consolidated Financial Statements. See Item 8, Note 14, “Notes Payable and Debt and Financing Arrangements”, to the Consolidated Financial Statements for further information.
Deposit liabilities on the Company’s Consolidated Balance Sheet at December 31, 2007 were $7,920,085. The difference from the amount included above relates to the discount on payments due in the future. The payment related to these liabilities varies primarily based on interest rates. The ultimate payments associated with these liabilities could differ from the Company’s estimate. As noted above, as a result of the downgrades of XLCA in January and February 2008, the Company will settle, by late March 2008, the majority of the GIC portfolio. See Item 8, Note 12 to the Consolidated Financial Statements, “Deposit Liabilities,” for further information.
Future policy benefit reserves related to Life operations were $6,772,042 on the Company’s Consolidated Balance Sheet at December 31, 2007. Amounts included above include an allowance for future premiums in respect of contracts under which premiums are payable throughout the life of the underlying policy. The value of the discount is also included for those lines of business that have reserves where future claim payments and future premium receipts can be estimated using actuarial principles. The timing and amounts of actual claims payments and premium receipts related to these reserves vary based on the underlying experience of the portfolio. Typical elements of the experience include mortality, morbidity and persistency. The ultimate amount of the claims payments and premium receipts could differ materially from the Company’s estimated amounts.
The agreements provide the Company with a Reinsurance Collateral Account in support of certain Covered Perils named in the Reinsurance Agreement. The initial Covered Perils will include United States wind, European wind, California earthquake and terrorism worldwide. After an initial three-month period, the covered perils as well as the attachment points and aggregate retention amounts may be changed by the Ceding Insurers in their sole discretion. This may result in a material increase or decrease in the likelihood of payment under the Reinsurance Agreement. On each date on which a Ceding Insurer withdraws funds from the Reinsurance Collateral Account, the Company shall issue and deliver to the Issuer an amount of XL Capital Ltd Series D Preference Shares having an aggregate liquidation preference that is equal to the amount of funds so withdrawn from the Collateral Account. The Company is obligated to reimburse Stoneheath for certain fees and ordinary expenses. The initial term of the Reinsurance Agreement will be for the period from the Closing Date through June 30, 2007, with four annual mandatory extensions through June 30, 2011 (unless coverage is exhausted there under prior to such date). The Ceding Insurers may thereafter extend the Reinsurance Agreement at their option for additional calendar quarters without limit (unless coverage is exhausted there under). The contingent put option is recorded at fair value with changes in fair value recognized in earnings. The Stoneheath preferred securities and, if issued, the XL Series D Preference Shares will pay dividends on a non-cumulative basis at a fixed rate of 6.868% per annum through October 15, 2011 and thereafter at a floating rate based on 3-month LIBOR, plus 3.12%.
The Company through SCA has historically provided various forms of credit enhancement including financial guarantee insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk-based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. Subsequent to June 6, 2007 an the deconsolidation of SCA, the Company’s involvement with such variable interest entities is limited to its reinsurance of SCA. In synthetic transactions, the Company guarantees payment obligations of counterparties including special purpose vehicles under credit derivatives referencing asset portfolios. The Company invests in CDOs, and other investment vehicles that are issued through variable interest entities as part of the Company’s risk asset portfolio.
In February 2003, the Company entered into an aggregate of $300.0 million of commercial paper-based credit facilities (the “Credit Facilities”). These facilities were increased to $500.0 million in June 2003. The proceeds of advances under the Credit Facilities were used to fund a trust account (“Trust”) to collateralize the reinsurance obligations of the Company under an intercompany quota share reinsurance agreement. The issued securities and the Company’s repayment obligations were recorded as a net balance on the Company’s balance sheet because the Company had a contractual legal right of offset. In February 2008, the Company terminated this arrangement, resulting in a repayment of $500.0 million and termination of the Trust.
The Private Securities Litigation Reform Act of 1995 (“PSLRA”) provides a “safe harbor” for forward-looking statements. Any prospectus, prospectus supplement, the Company’s Annual Report to ordinary shareholders, any proxy statement, any other Form 10-K, Form 10-Q or Form 8-K of the Company or any other written or oral statements made by or on behalf of the Company may include forward-looking statements that reflect the Company’s current views with respect to future events and financial performance. Such statements include forward-looking statements both with respect to the Company in general, and to the insurance and reinsurance sectors in particular (both as to underwriting and investment matters). Statements that include the words “expect”, “intend”, “plan”, “believe”, “project”, “anticipate”, “will”, “may”, and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
These consolidated financial statements include the accounts of the Company and all of its subsidiaries. These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant intercompany accounts and transactions have been eliminated. Certain amounts in 2006 and 2005 have been reclassified to conform to the current year presentation.
Unpaid losses and loss expenses and unpaid losses and loss expenses recoverable;
Insurance premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums written are recorded at the inception of the policy and are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Financial guarantee installment premiums are recorded as premiums written when due.
Acquisition costs, which vary with and are directly related to the acquisition of policies, consist primarily of commissions paid to
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales are made within the context of overall risk monitoring, changing information, market conditions generally and assessing value relative to other comparable securities. For further details on the factors considered in evaluation other than temporary impairment see Note 7 “Investments”.
The Company conducts its derivative activities in three main areas: investment related derivatives, weather and energy derivatives and credit derivatives written by SCA and reinsured by the Company. For further details related to derivative instrment see Note 15 “Derivative instruments”.
Changes in the fair value of a derivative used as a hedge of a net investment in a foreign operation, to the extent effective as a hedge, are recorded in the foreign currency translation adjustments account within AOCI. Cumulative changes in fair value recorded in AOCI are reclassified into earnings upon the sale or complete or substantially complete liquidation of the foreign entity. 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.
Investments that are considered available for sale are carried at fair value. The fair value of investments is based upon quoted market values where available, independent pricing services where quoted market values are not available, or by reference to broker or underwriter bid indications. The net unrealized appreciation or depreciation on investments, net of tax, is included in “accumulated other comprehensive income (loss).” Any unrealized depreciation in value considered by management to be other than temporary is charged to income in the period that it is determined.
All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of equities and fixed income investments are determined on the basis of average cost and amortized cost, respectively. Investment income is recognized when earned and includes interest and dividend income together with the amortization of premium and discount on fixed maturities and short-term investments. For mortgage-backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Prepayment fees or call premiums that are only payable to the Company when a security is called prior to its maturity, are earned when received and reflected in net investment income.
Contracts entered into by the Company with cedants which are not deemed to transfer significant underwriting and/or timing risk are accounted for as deposits, whereby liabilities are initially recorded at an amount equal to the assets received. The Company uses a portfolio rate of return of equivalent duration to the liabilities in determining risk transfer. An initial accretion rate is established based on actuarial estimates whereby the deposit liability is increased to the estimated amount payable over the term of the contract.
Guaranteed investment contracts are initially recorded at an amount equal to the value of assets received. The Company may use derivative instruments in order to hedge the Company’s exposure to fluctuations in interest rates related to these contracts. Changes in the fair value of the hedging instrument are recognized in income. The change in the fair value of the hedged item, attributable to the hedged risk, is recorded as an adjustment to the carrying amount of the hedged item and is recognized in income.
Certain life insurance and annuity contracts provide the holder with a guarantee that the benefit received upon death will be no less than a minimum prescribed amount. The contracts are accounted for in accordance with SOP 03-1 “Accounting and Reporting by Insurance Enterprises for certain Long-Duration Contracts and for Separate Accounts”, which requires that the best estimate of future experience be combined with actual experience to determine the benefit ratio used to calculate the policy benefit reserve.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“FAS”) No. 123, Accounting for Stock-Based Compensation (“FAS 123”), as amended by FAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure (“FAS 148”), under the prospective method for options granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for options under the disclosure-only provisions of FAS 123 and no stock-based employee compensation cost was included in net income as all options granted had an exercise price equal to the market value of the Company’s ordinary shares on the date of the grant. At December 31, 2007, the Company had several stock based Performance Incentive Programs, which are described more fully in Note 20, “Share Capital.” Stock-based compensation issued under these plans generally have a life of not longer than ten years and vest as set forth at the time of grant. Options currently vest annually over four years from the date of grant. The Company recognizes compensation costs for stock options and restricted stock on a straight-line basis over the requisite service period (usually the vesting period) for each award.
In 2004, the FASB issued SFAS No.123 (revised 2004) (“FAS 123(r)”), “Share-Based Payment,” which is a revision of FAS 123. FAS 123(r) superseded FAS 123 and APB 25, and amended FAS 95, “Statement of Cash Flows.” Generally, the approach to accounting for share-based payments in FAS 123(r) is similar to the approach described in FAS 123, which the Company adopted on a prospective basis in 2003. However, FAS 123(r) requires all share-based payments to employees, including grants of employee stock options (for all grant years), to be recognized in the financial statements over the vesting period based on their grant date fair values.
Fair values of investments and derivatives are based on published market values if available, estimates of fair values of similar issues, estimates of fair values provided by independent pricing services or estimates of fair values determined by the Company. Fair values of financial instruments for which quoted market prices are not available are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rates and the estimated amounts and timing of future cash flows. In such instances, the derived fair value estimates cannot be substantiated by comparison to independent markets and are not necessarily indicative of the amounts that would be realized in a current market exchange. Certain financial instruments, particularly insurance contracts, are excluded from fair value disclosure requirements of FAS 107, Disclosures about Fair Value of Financial Instruments. For further information on accounting policies relating to other financial instruments, investments, other investments, notes payable and debt, derivative instruments, and off-balance sheet arrangements, see Notes 2, 7, 9, 14, 15, and 16, respectively.
In September 2006, the FASB issued FAS 157, Fair Value Measurements (“FAS 157”) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, FAS 157 does not require any new fair value measurements. FAS No. 157 will be effective for interim and annual financial statements issued after January 1, 2008. The Company is currently evaluating the impact of FAS 157; however, it is not expected to have a material impact on the Company’s financial condition and results of operations as this guidance primarily addresses disclosure requirements.
In October 2006, the FASB issued proposed FASB Staff Position EITF 03-6-a, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities. This FASB Staff Position (FSP) addresses whether instruments granted in share-based payment transactions may be participating securities prior to vesting and, therefore, need to be included in the earnings allocation in computing basic earnings per share (EPS) pursuant to the two-class method described in paragraphs 60 and 61 of FASB Statement No. 128, Earnings per Share. A share-based payment award that contains a non-forfeitable right to receive cash when dividends are paid to common shareholders irrespective of whether that award ultimately vests or remains unvested shall be considered a participating security as these rights to dividends provide a non-contingent transfer of value to the holder of the share-based payment award. Accordingly, these awards should be included in the computation of basic EPS pursuant to the two-class method. The guidance in this proposed FSP would be effective in the first reporting period beginning after the FASB posts the final FSP to its website. All prior period EPS data will have to be adjusted retrospectively to reflect the provisions of the FSP. Under the terms of the Company’s restricted stock awards, grantees are entitled to the right to receive dividends on the unvested portions of their awards. There is no requirement to return these dividends in the event the unvested awards are forfeited in the future. Accordingly, this FSP will have an impact on the Company’s EPS calculations should the FASB issue the proposed guidance as final during 2008. The Company will continue to evaluate the potential impact of this guidance.
During February 2007, the FASB issued FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”), which permits entities to choose to measure many financial instruments and certain other items at fair value. A company must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option may be applied on an instrument by instrument basis, with a few exceptions. The fair value option is irrevocable (unless a new election date occurs) and the fair value option may be applied only to entire instruments and not to portions of instruments. FAS 159 will be effective for interim and annual financial statements issued after January 1, 2008.
On August 4, 2006, the Company completed the sale of approximately 37% of its then financial guarantee reinsurance and insurance businesses through an initial public offering (“IPO”) of 23.4 million common shares of SCA for proceeds of approximately $446.9 million. On June 6, 2007, the Company completed the sale of a portion of SCA’s common shares still owned by the Company through a secondary offering and thereby reduced its ownership of SCA’s outstanding common shares further from approximately 63% to approximately 46%. Accordingly, SCA is no longer a consolidated subsidiary or operating segment of the Company and the Company accounts for its remaining investment in SCA using the equity method of accounting. Upon completion of the secondary public offering on June 6, 2007 of 10.6 million SCA common shares, the Company received proceeds, net of offering costs, of approximately $316.3 million. The transaction resulted in a gain on sale of $81.3 million, representing the difference between the carrying value of the SCA shares sold and the secondary proceeds, net of offering costs. This gain includes the realization of $5.0 million of SCA’s other comprehensive loss, which had no effect on total shareholders’ equity.
Concurrent with the initial public offering (“IPO”) of SCA and subsequently, the Company has entered into certain service, reinsurance and guarantee arrangements with SCA and its subsidiaries, to govern certain aspects of the Company’s relationship with SCA. Prior to the sale of SCA shares through the secondary offering on June 6, 2007, the effect of these arrangements have been eliminated upon consolidation of the Company’s results.
The income statement impacts of all transactions with SCA have been included in “Net (loss) income from operating affiliates.”
The Company also provides certain reinsurance protections with respect to adverse development on certain transactions as well as indemnification under specific facultative and excess of loss coverages for subsidiaries of SCA: XL Financial Assurance (“XLFA”) and XL Capital Assurance (“XLCA”). The adverse development cover relates to a specific project financing transaction while the facultative covers generally reinsure certain policies up to the amount necessary for XLCA and XLFA to comply with certain regulatory and risk limits. The excess of loss reinsurance provides indemnification for the portion of any individual paid loss covered by XLFA in excess of 10% of XLFA’s surplus (XLFA’s surplus on a Bermuda statutory basis was approximately $375 million as at September 30, 2007), up to an aggregate amount of $500 million, and excludes coverage for liabilities arising other than pursuant to the terms of the underlying policies.
For the period from June 6, 2007 to December 31, 2007 the Company has incurred case losses of $300.0 million and $51.0 million on a net present value basis with respect to the excess of loss and facultative reinsurance agreements, respectively. In addition, the Company incurred $17.9 million in additional mark to market losses related to those underlying contracts written in derivative form. See Note 15 “Derivative Instruments” for further details on embedded credit derivatives. These losses were based on the Company’s examination of exposures under these agreements and have been recorded within “Net loss from operating affiliates”. These amounts represent the discounted value of expected losses net of related premiums and are discounted at approximately 5%. In the case of the excess of loss cover, the recorded loss represents the discounted value of a $500 million full limit loss. In addition, the Company recorded aggregate earned premiums of $2.0 million net of ceding commission related to the aforementioned agreements from June 6 to December 31, 2007. The Company also carried a net receivable of approximately $17.6 million, net unearned premiums of $39.6 million, net unpaid losses and loss expenses of $425.9 million (of which $351.0 million was incurred subsequent to the secondary offering on June 6, 2007) and derivative liabilities of $17.9 million in relation to these agreements as at December 31, 2007.
As at December 31, 2007, the Company’s total net exposure under its facultative agreements with SCA subsidiaries was approximately $7.7 billion of net par outstanding. Of this total, approximately $907 million of net par outstanding was related to RMBS and ABS CDOs.
The Company has also entered into certain guarantee agreements with subsidiaries of SCA. These guarantee agreements terminated with respect to any new business produced by SCA through the underlying agreements after the effective date of SCA’s IPO, but the agreements remain in effect with respect to cessions or guarantees written under these agreements prior to the IPO. The agreements unconditionally and irrevocably guarantee: (i) XLCA for the full and complete performance of XLFA’s obligations under its facultative quota share reinsurance agreement with XLCA, (ii) the full and complete payments when due of XLCA’s obligations under certain financial guarantees issued by XLCA and arranged by XL Capital Assurance (U.K.) Limited and (iii) Financial Security Assurance (“FSA”) for the full and complete performance of XLFA’s obligations under a FSA Master Facultative Agreement. The guarantees the Company has provided contain a dual trigger, such that the guarantees respond only if two events occur. Firstly, the underlying guaranteed obligation must default on payments of interest and principal, and secondly, the relevant SCA subsidiary must fail to meet its obligations under the applicable reinsurance or guarantee. As at December 31, 2007, the Company’s total net par outstanding falling under these guarantees was $75.2 billion. Indirect consumer mortgages exposures related to these guarantee agreements totaled approximately $2.9 billion related to RMBS and $3.3 billion related to ABS CDOs with greater than 50% RMBS collateral. Again, it is important to note that SCA subsidiaries must fail to meet their obligations under the applicable reinsurance or guarantee before XL would be required to respond to claims under these guarantees and as such, these exposures must be compared to the relevant SCA subsidiary’s current financial resources. In addition, based on all of the above factors, as well as the Company’s current estimates of defaults on the relevant underlying obligations and the Company’s judgment as to the current financial resources of the relevant SCA subsidiaries, the Company has concluded that no losses are expected under these guarantees and accordingly no loss reserves have been recorded. Future developments could expose the Company to potential payments under one or more of the guarantees which could be material to the Company.
As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with GICs which were correspondingly matched with invested assets. XLCA provided financial guarantee insurance policies insuring timely payment of GICs issued by XL Asset Funding Company I LLC (“XLAF”), a subsidiary of the Company. Based on the terms and conditions of the underlying GICs, upon downgrades of XLCA, all or portions of outstanding principal balances on such GICs would come due. In January and February 2008, several rating agencies downgraded SCA and its subsidiaries and as a result, the Company will settle, by late March 2008, the majority of the GIC portfolio. Management had prepared for this possibility and does not expect this liquidity need to have any significant negative impact on the Company’s financial position or results of operations.
For further information on the Company’s investment in SCA, see Note 8 “Investment in Affiliates”.
The earnings on the Company’s investment in Primus and other financial operating affiliates as well as the results of certain structured finance products are reported as part of the Corporate segment that includes the general investment and financing operations of the Company. In addition, the guaranteed investment contract and funding agreement businesses are now reported separately within the Other Financial Lines segment.
The Company evaluates the performance for both the Insurance and Reinsurance segments based on underwriting profit and evaluates the contribution from each of the Life Operations and Other Financial Lines segments. Other items of revenue and expenditure of the Company are not evaluated at the segment level for reporting purposes. In addition, the Company does not allocate investment assets by segment for its property and casualty operations. Investment assets related to (i) the Company’s Life Operations and Other Financial Lines segments and (ii) certain structured products included in the Insurance and Reinsurance segments, are held in separately identified portfolios. As such, net investment income from these assets is included in the contribution from each of these segments.
Insurance business written includes risk management and specialty lines. Risk management products comprise global property and casualty insurance programs for large multinational companies, including umbrella liability, products recall, U.S. workers’ compensation, property catastrophe, and primary property and liability coverages. Specialty lines products include the following lines of business: professional liability, environmental liability, political risk insurance, aviation and satellite, marine and offshore energy insurance, equine and other insurance coverages including program business. In addition, certain structured indemnity products structured by XLFS are included within the results of the Insurance segment covering a range of insurance risks including property and casualty insurance, certain types of residual value exposures and other market risk management products.
Life operations covers life reinsurance business written with life insurance companies, principally to help them manage mortality, morbidity, survivorship, investment and lapse risks. This includes a broad range of underlying lines of life assurance business, including term assurances, group life, critical illness cover, immediate annuities, disability income cover, and short-term accident and health business. This also covers a range of geographic markets, with an emphasis on the U.K., U.S., and Continental Europe.
The Other Financial Lines segment is comprised of the guaranteed investment contract (GIC) and funding agreement (FA) businesses. GICs are customized financial products that offer a guaranteed investment return to the purchaser. GIC issuance is driven by municipal and structured finance bond issuers needing to reinvest bond proceeds. For example, a municipal entity that raises funds for a particular project may invest such funds in a GIC pending their drawdown to complete the project. FAs are very similar to GICs, have known cash flows and are sold to institutional investors, typically through medium term note programs. GICs and FAs provide users guaranteed rates of interest on amounts invested with the Company.
The net results from P&C structured products includes net investment income, interest expense and operating expenses of $131.5 million, $85.0 million, and $23.5 million, respectively.
This includes net realized losses on investments of $116.5 million, net realized and unrealized gains on investment and other derivatives of $101.2 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss).
The net results from P&C structured products includes net investment income, interest expense and operating expenses of $100.6 million, $50.0 million, and $20.4 million, respectively.
This includes net realized gains on investments of $241.9 million, net realized and unrealized gains on investment and other derivatives of $28.8 million, but does not include unrealized appreciation or depreciation on investments, which are included in accumulated other comprehensive income (loss).
The Other Financial Lines segment is comprised of the guaranteed investment contract and funding agreement businesses. The net results from these products include net investment income, interest expense and operating expenses of $213.3 million, $166.4 million, and $13.2 million, respectively.
The addition to goodwill during 2007 was related to the Company’s purchase of Global Asset Protection Services LLC (“GAPS”). See Note 6, “Business Combinations” for further details. As at December 31, 2007 and 2006, goodwill and other intangible assets primarily related to the Reinsurance and Insurance segments were $1.4 billion and $0.4 billion, respectively.
The GAPS operation and XL Insurance’s existing loss prevention services will be merged to form XL GAPS. XL GAPS will employ more than 150 engineers worldwide, with a strong presence in America, Europe, Asia and Australia and will remain independent of XL’s underwriting operations and will continue to provide loss prevention consulting services to existing clients as well as to clients of the Company. The acquisition is intended to help the Company achieve its long-term growth plans in both the loss prevention market and as a primary insurer. The focus is to offer XL GAPS clients high quality risk management solutions.
On December 6, 2005 the Company received the report from the Independent Actuary in connection with the Company’s post-closing protection. The Independent Actuary’s report concluded that WSIC submitted Seasoned Net Reserve Amount (“SNRA”) and Net Premium Receivable Amount (“NPRA”) were closest to the Independent Actuary’s determinations of SNRA and NPRA. These determinations resulted in the Company receiving a net lump sum payment in the amount of approximately $575.0 million (including interest receivable) from WSIC. As the Company had recorded $1.4 billion in unpaid losses and loss expenses recoverable related to this protection, a loss of approximately $808.9 million, net of interest, was recorded in the fourth quarter of 2005.
On June 7, 2006, subsidiaries of the Company, entered into an agreement (the “Agreement”) with WSIC. The purpose of this Agreement is to release all actual or potential disputes, claims or issues arising out of or related in any way to: (i) the Liquidity Facility and the Sellers Retrocession Agreements, as well as (ii) subject to certain exceptions, the SPA.
The Agreement replaces the protections provided to the Company from WSIC for reinsurance receivables and recoverables under the Liquidity Facility and Sellers Retrocession Agreements noted above and described in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2005.
Net realized gains and losses in 2007 and 2006 included a loss of $611.0 million and $151.4 million, respectively, relating to certain fixed income, equity securities and other investments where the Company determined that there was an other than temporary decline in the value of those investments.
The total amount of other than temporary declines in value in 2007 included $608.3 million related to maturities and short-term investments, $2.6 million on equity securities and $0.1 million on other investments. The total amount of other than temporary declines in value in 2006 included $133.2 million related to fixed income securities, $2.8 million on equity securities, and $15.4 million on other investments.
The cost (amortized cost for fixed maturities and short-term investments), fair value, gross unrealized gains and gross unrealized (losses) of investments are as follows:
The Company had gross unrealized losses totaling $1,084.4 million at December 31, 2007, which it considers to be temporary impairments. Individual security positions comprising this balance have been evaluated by management, based on specified criteria, to determine if these impairments should be considered other than temporary. These criteria include an assessment of the severity and length of time securities have been impaired, along with management’s ability and intent to hold the securities to recovery, among other factors included below.
Factors considered in determining that additional other-than-temporary impairment charges were not warranted include; managements’ consideration of current and near term liquidity needs, an evaluation of the factors and time necessary for recovery, and the results of on-going retrospective reviews of security sales and the basis for such sales. Securities in an unrealized loss position at December 31, 2007 are comprised of sub-prime first liens and Alt-A asset backed securities, CDOs with insignificant residential mortgage collateral, unrealized foreign exchange losses on U.S. dollar investments held in foreign subsidiaries with little underlying value impairment and unrealized losses on investments supporting long-term liabilities which have no history of significant sales at a loss. Following a detailed review of the Company’s underlying sub-prime and related residential mortgage exposures (“topical assets”) described above, as well as a consideration of the broader structured credit market, the Company has concluded that the remaining investments in these asset classes have decreased in value due to technical spreads widening and broader market sentiment, rather than fundamental collateral deterioration. Topical assets are held primarily in the Company’s Other Financial Lines segment portfolios and management has put in place a strategy to monitor and address the liquidity needs associated with these portfolios with the intent of holding the positions to recovery. The fact that the underlying securities cash flows continue to be in accordance with their contractual terms, combined with manager evaluations of the fundamentals supporting the underlying positions, have lead management to conclude that the values of the investments for which it reports unrealized losses as at December 31, 2007 are not other than temporarily impaired, as management currently has the intent and ability to hold these securities for a period of time sufficient to allow for any anticipated recovery in market value.
The following is an analysis of how long each of those securities at December 31, 2006 had been in a continual unrealized loss position:
At December 31, 2007 and 2006, approximately $144.3 million and $142.4 million, respectively, of securities included in investments available for sale were loaned to various counter-parties through the Company’s securities lending program. At December 31, 2007 and 2006, approximately $146.2 million and $147.2 million, respectively, of cash collateral held in connection with these loans, is included in cash and cash equivalents, with a corresponding liability reflected in net payable for investments purchased.
Securities in an unrealized loss position were comprised of approximately 7,800 securities, of which 83% of the unrealized loss were securities with fair value to amortized cost ratios at or greater than 90%. The majority of these securities are high quality investment grade fixed maturities depressed due to broad overall market widening of credit spreads seen in the third and fourth quarter of 2007.
Management has done extensive analysis of SCA’s underlying financial guarantee portfolio to evaluate the exposures and underlying possible losses arising from recent credit market turbulence. Given Management’s view of the potential scale of SCA’s estimated losses along with the uncertainty facing the entire financial guarantee industry, the Company has reduced the reported value of its investment in SCA to nil from the reported equity method value of $669.8 million as at September 30, 2007. Recent market developments with respect to monoline industry and industry analyst reports have indicated that the fair value of any investment in the financial guarantee sector has very uncertain value at this point in time. Subsequent to December 31, 2007 SCA was downgraded by several ratings agencies, which significantly limits SCA’s ability to write new business. In addition, the shares in SCA held by the Company are unregistered and thus illiquid. Based on the nature of the Company’s investment in SCA and the resultant limitations on any future business models, management believes that the fair value of the Company’s investment in SCA is substantially less than the aggregate fair value of $117.0 million based upon the traded market value at December 31, 2007 of $3.89 per share. Management believe this decline in value is other than temporary.
The reported results of SCA are not sufficiently timely for the equity method to be applied currently, therefore as allowed under U.S GAAP, the Company reports such earnings on a one quarter lag. Management expects to continue this practice in future periods with appropriate consideration given by disclosure or otherwise to the effects of any known intervening events that materially affect the Company’s financial position or results of operations. The current write down in the reported investment value of SCA is based, in part, on the estimated losses SCA are expected to record in the fourth quarter of 2007 and as such management does not expect to report these losses again in the first quarter of 2008.
Recent Primus press releases indicate that the general widening of market credit spreads have significantly impacted Primus’ mark to market credit derivative liabilities resulting in a negative book value. The results of Primus have historically been reported on a one quarter lag, however, management believes that based on the signficance of the underlying book value change, it is appropriate at this time to write the investment down to nil consistent with the recently disclosed Primus fourth quarter results. As at December 31, 2007, the aggregate fair value of the Company’s investment in Primus would have been $104.5 million based upon the traded market value of Primus of $7.01 per share. As at December 31, 2007, Primus had total assets of $882.7 million, total liabilities of $852.7 million, outstanding preferred shares of $98.5 million and common shareholders deficit of $93.5 million. For the year ended December 31, 2007, Primus reported net credit default swap losses of $535.1 million and a net loss available to common shareholders of $563.5 million.
In addition to the writedowns noted above, during the years ended December 31, 2007, 2006, and 2005, the Company recorded other than temporary declines in the values of certain affiliates totaling $63.5 million, $19.8 million, and $2.5 million, respectively. Other than temporary declines in 2007, 2006 and 2005 related primarily to investment management affiliates.
See Note 18(c), “Commitments and Contingencies - Investments in Affiliates” for further information regarding commitments related to investment in affiliates.
Other investments include investments over which the Company does not have significant influence and whose fair value is generally unquoted. This includes investments in limited partnerships where the Company does not participate in the management of the partnerships, and investments in non-rated collateralized loan obligations. Income from other investments was $17.1 million and $9.1 million for the years ended December 31, 2007 and 2006, respectively. Unrealized gains from these limited private investment partnerships was $13.6 million and $10.0 million as at December 31, 2007 and 2006 respectively.
The Insurance segment net prior year reserve releases consisted of $95.0 million in property and $162.1 million in casualty lines of business, partially offset by net adverse development of $23.0 million, $7.0 million and $69.0 million in certain professional, marine and other lines of business, respectively. Casualty releases relate primarily to the European casualty portfolio in accident years 2002-2005. The professional lines development reflects net adverse prior year development of the Bermuda E&O portfolio and releases from the U.S. and European professional lines portfolios. Net adverse prior year development in other insurance lines relates to adverse development in discontinued specialty lines, surety and environmental, partially offset by favorable development in aerospace and political risk. Gross prior year releases totaled $177.6 million for the Insurance segment during 2007.
During 2005, total net adverse prior year development within the Insurance Segment was $1.02 billion of which $834.2 million resulted from the negative outcome of the Winterthur Decision. The remaining $186.0 million was comprised of net adverse development of $259.7 million in professional lines and $34.7 million within other specialty lines including runoff and discontinued business partially offset by releases of $108.4 million primarily in European casualty business.
During 2006, net overall favorable prior year reserve development for the year ended December 31, 2006 was $97.4 million. This overall favorable development was made up of releases of $133.0 million in property and other shorter-tail lines of business and partially offset by prior year adverse reserve development of $7.3 million in casualty and other lines and $28.3 million within structured indemnity lines. The overall net favorable development within property and other short-tail lines of $133.0 million included $75.4 million in adverse development specifically related to the 2005 catastrophes. The gross prior year development for the Reinsurance segment totaled $17.7 million favorable. This gross favorable development is less than the corresponding net development as net adverse development on the 2005 catastrophes was less significant than the gross adverse development due to reinsurance recoveries.
During 2005, net prior year reserves across the Reinsurance segment developed adversely by $93.5 million and consisted of reserve strengthening of $266.9 million in casualty and professional lines, and was partially offset by releases in other lines of business of $173.4 million.
The net income impact of case basis reserves with respect reinsurance provided to SCA subsequent to the secondary sale of SCA common shares on June 6, 2007 of $351.0 million is included in “Net loss from operating affiliates”, and the unpaid case reserves related to such losses are in unpaid losses and loss expenses. These losses are associated with the credit enhancement of certain ABS CDO exposures as well as residential mortgage backed securities backed by home equity lines of credit collateral. Certain of these underlying exposures were written by SCA in derivative form as credit default swaps. Consistent with both the Company’s and SCA’s accounting policies the unrealized fair value liability on those contracts written in derivative form include both an insurance reserve component and a mark to market liability. A component of the overall fair value liability is classified as a case reserve once the loss is considered probable and can be reasonably estimated. Such case reserves are reported on a discounted basis and net of the present value of related future premiums. The Company discounts such reserves using a discount rate of approximately 5%. The remainder of the liability is classified as a derivative liability. As at December 31, 2007 the derivative liability recorded by the Company with respect to these contracts was $17.9 million.
The Company utilizes tabular reserving for workers’ compensation unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% (2006: 5%). The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2007 and 2006 were $813.7 million and $812.1 million, respectively. The related discounted unpaid losses and loss expenses were $377.0 million and $367.1 million as of December 31, 2007 and 2006, respectively.
A review in 2006 and 2007 of older policy years revealed outstanding claims reported in prior years that were deemed to have asbestos exposure.
The estimation of loss and loss expense liabilities for asbestos and environmental exposures is subject to much greater uncertainty than is normally associated with the establishment of liabilities for certain other exposures due to several factors, including: (i) uncertain legal interpretation and application of insurance and reinsurance coverage and liability; (ii) the lack of reliability of available historical claims data as an indicator of future claims development; (iii) an uncertain political climate which may impact, among other areas, the nature and amount of costs for remediating waste sites; and (iv) the potential of insurers and reinsurers to reach agreements in order to avoid further significant legal costs. Due to the potential significance of these uncertainties, the Company believes that no meaningful range of loss and loss expense liabilities beyond recorded reserves can be established. As the Company’s net unpaid loss and loss expense reserves related to asbestos and environmental exposures are less than 1% of the total net reserves at December 31, 2007 and 2006, further adverse development is not expected to be material to the Company’s overall net loss reserves. The Company believes it has made reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues that would significantly affect its estimate for loss and loss expenses.
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $1.2 billion, $0.8 billion and $1.7 billion for the years ended December 31, 2007, 2006 and 2005, respectively.
The following table presents an analysis of total unpaid losses and loss expenses and future policy benefit reserves recoverable for the year ended December 31:
Interest expense of $421.1 million, $350.1 million and $227.7 million was recorded related to the accretion of deposit liabilities for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company enters into long duration contracts that subject the Company to mortality and morbidity risks and which were accounted for as life premiums earned. Future policy benefit reserves were established using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The average interest rate used for the determination of the future policy benefits for these contracts was 4.5% and 4.7% at December 31, 2007 and 2006, respectively. Total future policy benefit reserves for the year ended December 31, 2007 and 2006 were $6.8 billion and $6.5 billion, respectively.
The 2010 and 2012 5-year revolving credit facilities share a $1 billion revolving credit sub-limit.
In addition, during March 2007, the Company entered into an interest rate swap agreement in anticipation of the issuance of the 2027 Senior Notes. This transaction, which met the requirements of a cash flow hedge of a forecasted transaction under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, was entered into to mitigate the interest rate risk associated with the subsequent issuance of the 2027 Senior Notes. The gain on the settlement of the swap transaction on May 2, 2007 of $3.8 million was credited to Accumulated Other Comprehensive Income and is being amortized to interest expense over the 20-year term of the related debt.
On December 19, 2006, the Company replaced a $150 million letter of credit facility that matured in December 2006 with a new 364-day facility of the same amount.
In November 2004, the Company issued $350 million aggregate principal amount of 6.375% Senior Notes due November 2024. The bonds were issued at par and gross proceeds were $350 million. Related expenses of the offering amounted to approximately $2.0 million. Proceeds of these notes, together with proceeds form the issuance of the second tranche of 2014 senior notes described above, were used to redeem the CARZ as described below.
In general, all of the Company’s bank facilities, indentures and other documents relating to the Company’s outstanding indebtedness (collectively, the “Company’s Debt Documents”), as described above, contain cross default provisions to each other and the Company’s Debt Documents (other than the 6.5% Guaranteed Senior Notes indentures) contain affirmative covenants. These covenants provide for, among other things, minimum required ratings of the Company’s insurance and reinsurance operating subsidiaries and the level of secured indebtedness in the future. In addition, generally each of the Company’s Debt Documents provide for an event of default in the event of a change of control of the Company or some events involving bankruptcy, insolvency or reorganization of the Company. The Company’s credit facilities and the 6.58% Guaranteed Senior Notes also contain minimum consolidated net worth covenants.
Under the Company’s 364-day facilities, three-year credit facility, and five-year credit facilities described above, in the event that the Company XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur.
Under the Company’s ten-year private placement notes described above, in the event that the Company fails to maintain a financial strength rating of at least “A” from A.M. Best or XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A” from S&P, an event of default would occur. The Company currently has an “A+” rating from S&P and an “A” (stable) rating from A.M. Best.
The 6.5% Guaranteed Senior Notes indenture contain a cross default provision. In general, in the event that the Company defaults in the payment of indebtedness in the amount of $50.0 million or more, an event of default would be triggered under both the 6.5% Guaranteed Senior Notes indentures.
For the periods prior to the deconsolidation of SCA on June 6, 2007, the Company presents certain credit derivative transactions in the consolidated statements of income to include certain components of the change in fair value in “gross premiums written,” “net premiums earned” and “net losses and loss expenses incurred”, and in the consolidated balance sheet, certain components of the fair value in “unearned premiums” and “unpaid loss and loss expenses.” This presentation is applicable only to credit default swaps issued by the Company that are investment grade and that the Company intends, and has the ability, to hold to maturity, and is consistent with practices in the financial guarantee insurance industry for reporting the results of such instruments.
The change in fair value recorded for the weather and energy derivatives was a gain of $19.6 million, $28.7 million and $17.8 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company utilizes variable interest entities both indirectly and directly in the ordinary course of business. The Company, through SCA, has historically provided various forms of credit enhancement including financial guarantee insurance and reinsurance of structured transactions backed by pools of assets of specified types, municipal obligations supported by the issuers’ ability to charge fees for specified services or projects, and structured single risk based obligations including essential infrastructure projects and obligations backed by receivables from future sales of commodities and other specified services. The obligations related to these transactions are often securitized through variable interest entities. Subsequent to June 6, 2007 and the deconsolidation of SCA, the Company’s involvement with such variable interest entities is limited to its reinsurance of SCA. In synthetic transactions the Company guarantees payment obligations of counterparties including special purpose vehicles under credit derivatives referencing asset portfolios. The Company invests in equity tranches (or similar instruments) of collateralized debt obligations (“CDOs”), collateralized bond obligations (“CBOs”) and other investment vehicles that are issued through variable interest entities as part of the Company’s risk asset portfolio. Certain collateral facilities and contingent capital facilities are also structured using variable interest entities, in which the Company has a variable interest. The Company was not the primary beneficiary of any of these entities. In addition, the Company does not believe that any of such interests would be characterized as significant to the Company. The Company believes that the significance of the variability it absorbs as contemplated in paragraph 24 of FIN 46(R), must be considered in the context of the Company’s consolidated financial statements. The Company considers the significance of its share of the entity’s expected losses and expected residual returns in relation to the Company’s consolidated results of operations, whether the Company holds a first loss portion in the entity, and the rating of its exposure and probability of loss.
The Company’s reinsurance assets at December 31, 2007 and 2006 amounted to $5.5 billion and $6.1 billion respectively and resulted from reinsurance arrangements in the course of its operations. A credit exposure exists with respect to reinsurance assets as they may be uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
The Company’s available for sale investment portfolio is managed by external managers in accordance with guidelines that have been tailored to meet specific investment strategies, including standards of diversification, which limit the allowable holdings of any single issue. The Company did not have an aggregate investment in a single entity, other than the U.S. Government, in excess of 10% of the Company’s shareholders’ equity at December 31, 2007, 2006, or 2005.
The Company is exposed to the credit risk of certain SCA subsidiaries though certain guarantees provided to SCA and its subsidiaries. Based on the nature of the commitment combined with the Company’s extensive analysis of the relevant exposures, we have concluded that no losses are expected under these guarantees and accordingly no loss reserves have been recorded. For further details regarding these nature of these guarantees as well and managements assessment of the exposure see Note 3 “Security Capital Assurance”.
The Company has committed to invest in several limited partnerships as part of its overall corporate strategy. As of December 31, 2007, the Company has commitments which include potential additional add-on clauses, to invest a further $76.3 million over the next five years.
During 2003, the Company entered into a purchase, sale and leaseback transaction to acquire new office space in London. The Company has recognized a capital lease asset of $160.8 million and $166.3 million, and deferred a gain of $48.9 million and $50.4 million related to this lease at December 31, 2007 and 2006, respectively. The gain is being amortized to income in line with the amortization of the asset. The future minimum lease payments in the aggregate are expected to be $342.8 million and annually for the next five years are as follows:
At December 31, 2007 and 2006, $3.7 billion and $3.8 billion of letters of credit, respectively, were outstanding, 4.3% and 4.5% of which were collateralized by the Company’s investment portfolios, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements.
Three similar class actions have been filed against “XL Insurance Ltd” (“XLI”) and others in the United States District Court, for the Southern District of New York on behalf of shareholders of Security Capital Assurance, Inc. (“SCA”). The complaints, filed December 7, 2007, December 18, 2007 and January 8, 2008 name as defendants SCA, two SCA officers, (and in two of the cases) Goldman Sachs & Co., J.P. Morgan Securities, Inc., and Merrill Lynch, Pierce Fenner & Smith, Inc. All allege violations of various U.S. Securities laws against the defendants arising from purchases of SCA shares in the June 6, 2007 secondary offering and shortly before. The complaints allege, among other things, that the Registration Statement and other public disclosures made by SCA and individual defendants contained untrue statements of material facts and omitted other necessary facts to make the statements not misleading. The complaints allege that the disclosures failed to disclose that SCA was materially exposed to extremely risky securities (“RMBS”) relating to sub-prime real estate mortgages. The allegations against XLI claim it is liable as a selling shareholder and as a party that “controlled” SCA during the relevant time period. It is expected that the cases will be consolidated and an amended complaint may be filed. The Company intends to vigorously defend these claims.
Legal actions are subject to inherent uncertainties, and future events could change management’s assessment of the probability or estimated amount of potential losses from pending or threatened legal actions. Based on available information, it is the opinion of management that the ultimate resolution of pending or threatened legal actions, both individually and in the aggregate, will not result in losses having a material effect on the Company’s financial position at December 31, 2007.
The authorized share capital is 999,990,000 ordinary shares of a par value of $0.01 each 20,000,000 Series C preference ordinary shares of par value $0.01 each, 350,000 Series D preference shares of par value $0.01 each, and 1,000,000 Series E preferable ordinary shares of par value $0.01 each. Holders of Class A ordinary shares are entitled to one vote for each share. All ordinary shares in issue at December 31, 2007 are Class A ordinary shares.
The Employee Share Purchase Plan (the “ESPP”) was approved by the shareholders of the Company on May 10, 2002; however, the Company discontinued the ESPP effective January 1, 2006. The ESPP was administered by a committee which consisted of members of the Compensation Committee of the Company’s Board of Directors. The ESPP had two offering periods a year. The first period commenced on July 1, 2002. All employees of the Company and its designated participating subsidiaries, were eligible to participate in the ESPP provided they had been employed at least one month prior to the start of the offering period and they did not hold more than 5% of the Company’s total stock, including stock acquired in the current period. Employees could invest up to 20% of their total monthly cash compensation towards the purchase of the Company’s shares up to a total market value (measured on the first day of the offering period) of U.S. $25,000. The total number of shares purchased in any offering period could not exceed 1,000 shares. Employees who enrolled in the ESPP could purchase the Company’s shares at a 15% discount on the lesser of the market price at the beginning or at the end of the six month offering period. Once purchased, employees could sell or transfer their shares to someone else’s name only during an Open Trading Window. Participants in the ESPP were eligible to receive dividends on the Company’s shares. A total of 1,255,000 ordinary shares were authorized to be issued under the ESPP. The number of shares issued during the year ended December 31, 2005 was 114,177.
During the years ended December 31, 2007, 2006 and 2005, the Company granted 52,500, 187,804 and 1,877,500 options, respectively, to purchase its ordinary shares to directors and employees related to incentive compensation plans, with a weighted average grant-date fair value of $20.98, $16.95 and $17.17, respectively. During the years ended December 31, 2007, 2006, and 2005, the Company recognized $13.1 million, $23.4 million and $17.6 million, respectively, of compensation expense, net of tax, related to its stock option plan. Total intrinsic value of stock options exercised during the years ended December 31, 2007, 2006 and 2005 was $13.5 million, $14.7 million and $17.4 million, respectively.
Available for grant includes shares that may be granted as either stock options or restricted stock.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the 2007 fiscal year and the exercise price, multiplied by the number of in-the-money-options) that would have been received by the option holders had all option holders exercised their options on December 31, 2007. Total unrecognized stock based compensation expense related to non-vested stock options was approximately $8.6 million as of the end of December 31, 2007, related to approximately 1.0 million options, which is expected to be recognized over a weighted-average period of 1.3 years. The Company received cash of $53.4 million from exercises of stock options and recorded associated tax benefits of $1.6 million on stock options exercised during the year ended December 31, 2007.
Non-vested restricted stock awards as of December 31, 2007 and for the year then ended for the Company were as follows:
The Company provides pension benefits to eligible employees through various defined contribution and defined benefit retirement plans sponsored by the Company, which vary for each subsidiary. Plan assets are invested principally in equity securities and fixed maturities.
The Company has qualified defined contribution plans which are managed externally and whereby employees and the Company contribute a certain percentage of the employee’s gross salary into the plan each month. The Company’s contribution generally vests over five years. The Company’s expenses for its qualified contributory defined contribution retirement plans were $46.5 million, $47.3 million and $40.9 million in the years ended December 31, 2007, 2006 and 2005 respectively.
In addition, certain former employees have received benefit type guarantees, not formally a part of any established plan. These agreements are not included in the tables below, however, the liability recorded with respect to these agreements as at December 31, 2007 and 2006 was $5.5 million and $5.6 million, respectively, representing the entire unfunded projected benefit obligations.
In addition during 2003 six members who are still employed in by the Company in the U.K. transferred from a defined benefit plan into a defined contribution plan. These employees have a contractual agreement with the Company that provides a “no worse than final salary pension” guarantee in the event that they are employed by the Company until retirement, whereby the Company guarantees to top-up their defined contribution pension to the level of pension that they would have been entitled to receive had they remained in the defined benefit scheme. This arrangement is not included in the tables below, however, the pension liability recorded with respect to these individuals as at December 31, 2007 was $3.5 million representing the entire unfunded projected obligation.
Certain contributory defined benefit pension plans exists in several European Countries, most notably Germany, which are closed to new entrants. Benefits are generally based on length of service and compensation defined in the related agreements.
In 2007, four quarterly dividends were paid at $0.38 per share to all ordinary shareholders of record as of March 15, June 11, September 10 and December 10.
In 2005, four quarterly dividends were paid at $0.50 per share to all ordinary shareholders of record as of March 10, June 9, September 8 and December 8.
The Company’s Indian subsidiary is not subject to certain income and capital gains taxes under current Indian law. This subsidiary is exempt from these taxes until March 31, 2009 pursuant to the Income Tax Act 1961. The subsidiary is subject to a Minimum Alternative Tax as of April 1, 2007.
Deferred income taxes have not been accrued with respect to undistributed earnings of foreign subsidiaries. If the earnings were to be distributed, as dividends or otherwise, such amounts may be subject to withholding taxation in the state of the paying entity. Currently however, no withholding taxes are accrued with respect to the earnings, as it is the intention that such earnings will remain reinvested indefinitely.
The Company’s policy is to recognize any interest accrued related to unrecognized tax benefits as a component of interest expense and penalties in the tax charge. As at December 31, 2007, the Company has accrued liabilities, relating to interest and penalties, of $1.0 million.
The income tax provisions for the years ended December 31, 2007, 2006 and 2005 are as follows:
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years ended December 31, 2007 and 2006 is provided below:
The valuation allowance at December 31, 2007 and December 31, 2006 of $370.5 million and $218.6 million, respectively, related to net operating loss carry forwards in Switzerland and net unrealized capital losses and realized capital loss carry forwards in the U.S. that may not be realized within a reasonable period. As of December 31, 2007, the Company had net unrealized capital losses and realized capital loss carry forwards of approximately $404 million and $74 million respectively in the U.S., against which a valuation allowance of approximately $167 million had been established. Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized.
As of December 31, 2007, net operating loss carry forwards in the U.K. were approximately $624.4 million (inclusive of cumulative currency translation adjustments) and have no expiration. As of December 31, 2007, net operating loss carry forwards in Switzerland were approximately $974.7 million and will expire in future years through 2014. During 2007, the payment of an intra-group dividend resulted in the utilization of $129.9 million of the net operating loss carry forwards in Switzerland.
Statutory assets in Bermuda include investments in other U.S. and international subsidiaries reported seperately herein.
Unless permitted by the New York Superintendent of Insurance, the Company’s lead property and casualty subsidiary in the United States (“XLRA”) may not pay dividends to shareholders which in any twelve month period exceed 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 law also provides that any distribution that is a dividend may only be paid out of statutory earned surplus. At December 31, 2007, and 2006, XLRA had statutory earned surplus of $91.3 million and $273.7 million, respectively. At December 31, 2007, XLRA’s statutory policyholders’ surplus was $2.1 billion, and accordingly, the maximum amount of dividends XLRA can declare and pay in 2008, without prior regulatory approval, is $91.3 million. At December 31, 2007, three of the seven property and casualty subsidiaries directly or indirectly owned by XLRA had a statutory earned deficits ranging from $1.7 million to $21.5 million and two of the seven subsidiaries had statutory earned deficits ranging from $14.4 million to $14.6 million at December 31, 2006.
Dividends are non-cumulative and paid as declared by the Board of Directors of XL Life Insurance and Annuity Company (XLLIAC). Pursuant to regulatory requirements, the payment of dividends without prior approval from the Illinois Department of Insurance for life insurance companies is limited to the greater of 10 percent of XLLIAC’s policyholder surplus as of the preceding December 31, or the net gain from operations for the preceding 12-month period ending December 31. The payment of dividends cannot be made except from XLLIAC’s surplus profits arising from its business. As at December 31, 2007, XLLIAC’s surplus profits were negative. Under these restrictions, XLLIAC cannot declare or distribute any dividends in 2008. Under these circumstances, XLLIAC would need to request permission for an extraordinary dividend from the Illinois Department of Insurance.
Unless permitted by the Registrar of Companies, the Company’s significant Bermuda based subsidiaries may not pay dividends which would exceed 25% of their total statutory capital and surplus at the prior year end.
XL Capital Finance (Europe) plc (“XLFE”) is a wholly owned finance subsidiary of the Company. In January 2002, XLFE issued $600 million par value 6.5% Guaranteed Senior Notes due January 2012. These Notes are fully and unconditionally guaranteed by the Company. The Company’s ability to obtain funds from its subsidiaries to satisfy any of its obligations under this guarantee is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which the Company operates including Bermuda, the U.S. and the U.K., among others. Required statutory capital and surplus for the principal operating subsidiaries of the Company was $5.3 billion as of December 31, 2007.