The Company operates in the United States, Bermuda, Europe and various other locations around the world. In 1997, the Company acquired commercial real estate in Hamilton, Bermuda for the purpose of securing long-term office space for its worldwide headquarters. The development was completed in April 2001. The total cost of this development, including land, was approximately $126.6 million.
In July 2003, the Company acquired new offices at 70 Gracechurch Street, London, which have become the Company’s new London headquarters. The acquisition was made through a purchase, sale and leaseback transaction. The move to the new offices was completed in 2004 and consolidated the Company’s London businesses in one location. The Company has recorded a capital lease asset and liability of approximately $150.0 million related to this transaction.
Results for all periods subsequent to July 1, 2001 include the results of Winterthur International, which was acquired with effect from this date. The results also include the consolidation of XL Re Europe, which has been accounted for as a subsidiary with effect from January 1, 2002. In the years ended December 31, 2001 and 2000, the Company’s share of net income of Le Mans Ré (now known as XL Re Europe) was included in equity in net income of operating affiliates. The Company’s net income for the years ended December 31, 2003, 2002 and 2001 was impacted by the September 11 event. The effect of all of these items should be considered when making period to period comparisons of the Company’s results of operations and financial condition and liquidity. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis.
The Company also generates revenue from investment activities through returns on its investment portfolio. The Company’s current investment strategy seeks to support the liabilities arising from the operations of the Company, generate investment income and build book value over the longer term. During 2004, interest rates in the U.S. increased moderately and the yield on the benchmark 5-year treasury rose from 3.25% to 3.61%. Interest rates declined in the U.K., where the yield on the benchmark 5-yr Gilt fell from 4.60% to 4.49% and in the Euro-zone, where the yield on the benchmark 5-yr German Bund fell from 3.50% to 3.03%.
In 2004, the Company generated net realized gains from both its equity and fixed income portfolios reflecting the overall performance of capital markets and the deterioration of the U.S. dollar relative to foreign currencies. In 2003, the Company generated net realized gains from both its equity and fixed income portfolios reflecting the overall improvement in capital markets and narrowing of credit spreads.
The Company’s profitability in any given period is based upon its premium and investment revenues as noted above, less net losses incurred and expenses. Net losses incurred are based upon claims paid and changes to unpaid loss reserves. Unpaid loss reserves are estimated by the Company and include both reported loss reserves and reserves for losses incurred but not reported. The Company’s results for 2004 were significantly impacted by the catastrophe activity in the year which resulted in $591.2 million in estimated net loss and loss expenses, combined with adverse prior year development in certain lines of the Company’s insurance segment. See further information below. The Company’s results for 2003 and 2002 were negatively impacted by an increase to reserves established in prior years primarily relating to its North American casualty reinsurance business written in the 1997 through 2001 underwriting years. In the third quarter of 2003, the Company received reported claims that were in excess of the Company’s expected claims and the Company increased loss reserves by $184.0 million and began an extensive claims audit review of its ceding companies for this book of business. Upon completion of this claims audit review as well as the Company’s scheduled annual reserve review, the Company increased loss reserves by $694 million in the fourth quarter of 2003. This increase was net of a $197 million release of reserves relating to the September 11 event. See further information under “Reinsurance - General Operations” below.
One way that the Company evaluates the performance of its insurance and reinsurance general operations is the underwriting profit or loss. The Company does not measure performance based on the amount of gross premiums written. Underwriting profit or loss is calculated from premiums earned and fee income, less net losses incurred and expenses related to the underwriting activities. As noted above, the Company’s underwriting profit and loss for the last three years have been negatively impacted by net losses incurred from catastrophic losses and adverse development of prior year loss reserves. Partially offsetting this has been the increase in premium rates and favorable underwriting terms and conditions during 2002 and 2003. Any changes to loss reserves affect the calculation of underwriting profit or loss but most often do not directly affect the Company’s cash flow in the same period. See further discussion below. Barring any unusual catastrophic loss events, the Company expects to produce an underwriting profit in 2005.
Net investment income from its general operations is an important measure which affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due, and thus a significant part of the portfolio is in fixed income securities. Net investment income is affected both by the size of the portfolio and the level of market interest rates. In 2004 U.S. interest rates increased moderately while interest rates in the U.K. and Euro-zone declined. The size of the portfolio is also impacted by cash flow generated from operations which has been positive during the last three years and which the Company currently expects to be positive in 2005.
Management also views the change in the Company’s book value per ordinary share as an additional measure of the Company’s performance. Book value per share is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income and also any changes in the net unrealized gains and losses on its investment portfolio. The Company’s book value per ordinary share increased in 2004 primarily as a result of an increase in net income com-
bined with an increase in the net unrealized gains on the investment portfolio. The increase in unrealized gains on the Company’s fixed income portfolio was primarily a result of the foreign exchange benefits for non-U.S. dollar investments partially offset by a moderate increase in interest rates in the U.S.
Return on average ordinary shareholder’s equity (“ROE”) is a widely used measure of any company’s profitability. It is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The Company establishes minimum target ROE’s 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 exit these lines. In addition, the Company’s compensation of its senior officers is significantly dependant on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE. The Company’s ROE’s for the last three years have been mainly affected by its general operations’ underwriting results and investment income. In addition to those items, in 2004 the Company had realized gains from investments and derivatives of $324 million which contributed 5.1% to the ROE.
Management continues to focus on the settlement and collection of certain post-closing balances under the sale and purchase agreement, as amended (“SPA”) and other contractual agreements, related to the 2001 acquisition of the Winterthur International operations from Winterthur Swiss Insurance Company. For further information, see “Unpaid losses and loss expenses recoverable” Item 8, Note 5(b) to the Consolidated Financial Statements.
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 Lloyds, and also to provide the Company with liquidity as required. These facilities are provided to the Company from commercial banks and generally are renewed every year. The Company has also utilized “off balance sheet” transactions in order to obtain more collateral capacity (these transactions are described below under “Variable Interest Entities and Other Off Balance Sheet Arrangements”). As the Company writes more business, its collateral requirements will increase. A key challenge for management is to ensure that sufficient collateral capacity is available as to not hinder future writing of business.
As a property and casualty company, the Company must ensure that it has sufficient funds to settle claims promptly, especially in the event of a major catastrophic event. Management is focused on making sure that liquidity requirements are supported by both having lines of credit facilities available to the Company as well as the
The Company’s net income and other financial measures as shown above for the three years ended December 31, 2004 have been affected, among other things, by the following significant items:
1) Significant large catastrophe activity in 2004 (Florida hurricanes and the Tsunami in South Asia);
2) Net adverse prior year loss development in general insurance and reinsurance operations;
4) A favorable underwriting environment in 2002 and 2003 with increased competition in 2004;
5) Other than temporary declines in investments in 2002 and 2003.
While these are management’s best estimates at this time, they could change as more information becomes available. In estimating the impact of these catastrophes on the Company, premium payments required to reinstate reinsurance policies have been accrued. Premiums from insureds required to reinstate their insurance or reinsurance coverage with the Company have also been accrued in the estimate.
The net adverse prior period loss development in the years ended December 31, 2003 and 2002 related primarily to the Company’s general reinsurance operations and principally to losses on business written in the 1997 through 2001 underwriting years in the Company’s U.S. casualty reinsurance business. In the third quarter of 2003, the Company experienced a significant increase in claims reported that was in excess of the Company’s expected loss development based on historical reporting patterns and recorded an increase to reserves of $184 million related to this book of business. As a result of this increase, the Company began a detailed claims audit review of the cedents contributing to this increase and the lines of business affected were primarily directors’ and officers’, errors and omissions, medical malpractice, commercial umbrella and general liability. Upon completion of this claims audit review, the Company increased case and IBNR reserves relating to this book of business for a total of $663 million in the fourth quarter of 2003. The Company monitors actual against expected reported claims on an ongoing basis. To the extent that actual experience on loss reserves differs significantly for this, or any other line of business, the Company would again expand its normal and ongoing cedant review program accordingly.
3. Growing asset base and positive performance from investments in affiliates.
4. A favorable underwriting environment in 2003 and 2002 with increased competition in 2004.
As noted above, competition increased in 2004 in most lines of business resulting in some pricing reductions and general softening of the market. In the two years ended December 31, 2003 and 2002, the Company had experienced pricing increases and improved terms and conditions across most of the lines of business it writes. This is discussed further within the segments below.
The general economy in the U.S. and the investment markets improved in 2004 relative to 2003. For example, Moody’s reported that 57 issuers defaulted in 2004 as compared with 77 issuers in 2003. The Company experienced better default experience than the Moody’s default data would have indicated. As a percentage of the total fixed income portfolio, the write down for other than temporary declines was negligible in 2004 as compared with 0.6% in 2003 and 1.4% in 2002.
At December 31, 2004 and 2003, the Company’s total gross reserves for unpaid losses and loss expenses were $19.6 billion and $16.6 billion, respectively, of which $9.5 billion and $8.4 billion related to case reserves for reported claims and $10.1 billion and $8.2 billion for IBNR reserves, respectively.
With respect to the Company’s insurance operations, the Company is notified of insured losses and records a case reserve for the estimated amount of the settlement, if any. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of legal counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. With respect to the Company’s reinsurance general operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the estimated ultimate cost of a loss. With respect to the Company’s financial products and services financial operations, financial guaranty claims incurred on policies written on an insurance basis are established consistent with the Company’s insurance operations and financial guaranty claims incurred on policies written on a reinsurance basis are established consistent with the Company’s reinsurance operations.
The ratio of IBNR to total reserves has increased in recent years due to the growth of casualty business written over that period. The ratio of IBNR to total reserves is higher for more recent years’ business because these immature years have relatively fewer claims reported and, as a result, a higher proportion of claims reserves are based on experience in respect of incurred but not reported losses. As each prior year of business matures and claims become known, the ratio of IBNR to total reserves will typically decline, all other factors remaining constant. Since the Company has experienced rapid premium volume growth in recent years, the ratio of IBNR to total reserves has increased because the Company’s aggregate exposure has become relatively less mature. Conversely, in a situation of declining premium volume, this ratio will typically decline, all other factors remaining constant. The Company writes insurance and reinsurance business in many different lines. Typically, the ratio of IBNR to total reserves is greater for casualty lines (which are longer tail in nature) than for property lines due to the policy forms utilized and timing of loss reporting. In recent years, casualty lines have increased as a proportion of the Company’s business when compared to property lines (which are shorter tail in nature).
Reserve volatility was analyzed for each line of business within each of the reinsurance and insurance segments’ general operations 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 based on a study of the Company’s historical data supplemented by industry data. 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.
The Company writes both “short-tail” and “long tail” lines of business. “Short-tail’ and “long-tail” describe the time between the receipt of the premium from a policy and the final settlement of any loss incurred under such policy. Short-tail lines include property catastrophe, other property and certain marine and aviation lines where, on average, the settlement period may be up to 24 months. Long-tail lines, on the other hand, include the Company’s casualty business in which claims may take up to 30 years to be reported and settled. The increase in the time associated with ultimate settlement of a claim is directly related to an increase in the amount of judgment required to establish loss reserves, especially IBNR reserves.
In the Company’s reinsurance general operations, case reserves for reported claims are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the estimated ultimate cost of a loss.
Except for certain workers’ compensation and long-term disability liabilities, the Company does not discount its unpaid losses and loss expenses. The Company utilizes tabular reserving for workers’ compensation and long-term disability unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% at December 31, 2004 and 2003. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. A 1% reduction in the interest rate would increase unpaid loss and loss expense reserves and net incurred loss and loss expenses by approximately $25.7 million and $24.0 million at December 31, 2004 and 2003, respectively, based on the current estimated amount and payout of the liabilities. See Item 8, Note 9 to the Consolidated Financial Statements.
The Company is aware of the SEC’s recent review of the loss reserving practices in the financial guaranty industry. The Company recognizes that there is diversity in practice among financial guaranty insurers and reinsurers with respect to their accounting policies. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60 “Accounting and Reporting by Insurance Enterprises” (“FAS 60”) and FASB Statement of Financial Accounting Standards No. 97 “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“FAS 97”), do not specifically address the unique characteristics of financial guaranty insurance contracts. Consequently, the accounting principles applied by the industry have evolved over time and incorporate the concepts of both short-duration and long-duration contracts accounting under the provisions of FAS 60 and FAS 97. It is the Company’s understanding that the SEC has requested that the FASB review this matter and provide guidance for the accounting of financial guaranty insurance contracts. The Company will continue its loss reserving methodology as noted in Note 2 (k) to the Consolidated Financial Statements until further guidance is provided by the SEC or the FASB. The Company had net reserves for financial guaranty insurance contracts of $120.2 million and $62.0 million at December 31, 2004 and 2003, respectively.
1. At the time of this transaction, the Company entered into a liquidity facility with the Seller. At the time of the payment of the net reserve seasoned amount, the Company has the right to repay up to the balances outstanding on this facility by assignment to the Seller of an equal amount of receivables relating to reinsurance recoverables selected by the Company. The payable balance related to this facility is included within Other liabilities on the Company’s balance sheet at December 31, 2004 and amounted to approximately $281 million at that date.
The Company may record a loss in future periods if any or all of the following occur:
Most of the Company’s future policy benefit reserves relate to annuity portfolio reinsurance contracts under which the Company makes annuity payments throughout the term of the contract for a specified portfolio of policies.
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 sufficient 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, 2004, 2003, and 2002, there were no adjustments to the locked-in assumptions for any of these contracts.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $3.9 billion and $2.7 billion at December 31, 2004 and 2003, respectively. The Company holds the investment assets backing these liabilities. These investments are primarily fixed income securities with maturities that closely match the expected claims settlement profile. A 0.1% decrease in the investment yield assumption would result in a $36 million increase in the value of future claims related to annuity portfolio reinsurance.
As stated above, the future policy benefit reserves include provisions for adverse deviation in excess of best estimate assumptions that amounted to approximately $145 million and $125 million at December 31, 2004 and 2003, respectively. The future policy benefit reserves would only be increased if these provisions for adverse deviation became insufficient in the light of emerging claims experience. The present value of future claims would increase by approximately $13 million if mortality rates were to decrease by 1% in all future years, relative to the reserving assumptions.
The Company also provides reinsurance of term assurance and critical illness policies. The future policy benefit reserves for these contracts amounted to $41 million and $15 million at December 31, 2004 and 2003, respectively. Future policy benefit reserves are established in accordance with the provisions of FAS 60, including the lock-in of “padded” assumptions at inception with periodic review against experience.
The liabilities relate to in-force blocks of business, comprising underlying insurance policies that provide mainly lump sum benefits if the policyholder dies or becomes sick. For term assurance, the liabilities are therefore driven by the rates of mortality and for critical illness cover, the liabilities are driven predominantly by the rates at which policyholders become sick (where sickness is defined by the treaty conditions), i.e., the morbidity rates. A 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $0.4 million, while a 1% increase in the morbidity rate would increase the value of future claims by approximately $0.4 million.
The Company’s deposit liabilities at December 31, 2004 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 Company has not had any significant change in these assumptions during the last three years ended December 31, 2004. The interest expense reported due to the accretion of deposit liabilities associated with structured insurance and reinsurance contracts was $59.4 million, $92.9 million and $65.9 million for the years ended December 31, 2004, 2003 and 2002, 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 $14.1 million on an annualized basis.
The fair value of weather and energy derivatives is determined through the use of quoted market prices where available. Where quoted market prices are unavailable, the fair value is estimated using available market data and internal pricing models using consistent statistical methodologies. Estimating fair value of instruments which do not have quoted market prices requires management’s judgment in determining amounts which could reasonably be expected to be received from, or paid to, a third party in settlement of the contracts. The amounts could be materially different from the amounts that might be realized in an actual sale transaction. Fair values are subject to change in the near-term and reflect management’s best estimate based on various factors including, but not limited to, actual and forecasted weather conditions, changes in commodity prices, changes in interest rates and other market factors. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” for sensitivity analysis.
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. Day to day management of the Company’s investment portfolio is outsourced to third party investment managers. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses that are considered temporary until such losses are recovered, the dynamic nature of the portfolio management may result in a subsequent decision to sell the security and realize the loss, based upon a change in market and other factors described above. The Company believes that subsequent decisions to sell such securities are consistent with the classification of the Company’s portfolio as available for sale.
As mentioned above, the Company considers its intent and ability to hold a security until the value recovers as part of the process of evaluating whether a security with an unrealized loss represents an other than temporary decline. However, this factor on its own does not dictate whether or not the Company recognizes an impairment charge. The Company believes its ability to hold such securities is supported by positive and sufficient cash flow from its operations and from maturities within its investment portfolio in order to meet its claims payment obligations arising from its underwriting operations without selling such investments. In this regard, cash flow from operating activities was $4.4 billion and $3.4 billion in 2004 and 2003, respectively.
The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company has capitalized net operating tax losses of $186 million and $225.2 million against which a valuation allowance of $68.5 million and $18.3 million at December 31, 2004 and 2003, respectively, has been established. The deferral of benefits from tax losses is evaluated based upon management’s estimates of the future profitability of the Company’s taxable entities based on current forecasts and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would 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.
The Company utilizes variable interest entities both directly and indirectly or not in the ordinary course of business. The Company must assess consolidation of variable interest entities based on whether the Company is the primary beneficiary of the entity. The company that absorbs a majority of the expected losses or residual rewards of the entity is deemed to be the primary beneficiary and is therefore required to consolidate the entity. The determination of expected losses and expected residual returns requires the Company to estimate the expected cash flows of the entities and measure the expected variability of these cash flows. The use of different assumptions to determine the expected cash flows and variability could affect the Company’s determination of the primary beneficiary. The assumptions used
Gross and net premiums written increased by 14.1% and 18.8%, respectively, for the year ended December 31, 2004 compared with the year ended December 31, 2003. These increases were primarily due to new business in the casualty and professional lines, multi year contracts written in the year and favorable foreign exchange movements. The most significant growth was due to new business product offerings in the areas of primary casualty, specialty professional and property catastrophe risks. The new insurance initiatives added, in total, approximately $280.0 million to gross premiums written for the year. The strengthening of the U.K. sterling and the Euro against the U.S. dollar, as compared to 2003, accounted for approximately $173.0 million of the increase in gross premiums written in the year. Partially offsetting the growth in gross and net premiums written in 2004 were rate reductions in most property and professional lines as well as growing rate pressures on most casualty lines. Net premiums written have grown by a larger percentage than gross premiums written primarily as a result of ceded reinsurance commutations related to professional lines.
Net premiums earned increased in each of the three years ended December 31, 2004, 2003 and 2002 due to the increases in net premium written in the current and prior years, as noted above. Growth in net premiums earned in 2004 and 2003 were partially offset by several non-renewed portfolios as the earned premium impact of the non-renewed business lags behind the written premium impact. Combined casualty and professional liability insurance net premiums earned increased from $1.36 billion in 2002 to $1.96 billion in 2003 to $2.36 billion in 2004.
Fee income and other increased in 2004 as compared to 2003 primarily due to the income recorded on the sale of property in London, combined with fees generated by the Company’s professional lines start up businesses for administration of third party portfolios. Fee income and other decreased in 2003 as compared to 2002 primarily due to $21.0 million of contingent income received in the fourth quarter of 2002 that related to a sale in 1999 of the motor business written by the Company’s Lloyd’s syndicates. In addition, at the end of 2002, the Company discontinued certain consulting and administration services related to the Winterthur International operations for employee benefit plans of unrelated companies.
Exchange gains in each of the last three years were primarily due to a decline in the value of the U.S. dollar against U.K. sterling, Euro and Swiss franc in those operations that have those currencies as their functional currency and are exposed to net monetary liabilities denominated in U.S. dollars. The gain in 2003 was partially reduced by a hedge put in place by the Company in February 2003 to cover part of its exposure to a U.K. sterling reinsurance recoverable balance.
The decrease in the underwriting profit in 2004 as compared with 2003 and the increases in 2003 as compared with 2002 were also reflective of the combined ratios, as shown below. The following table presents the ratios for the insurance segment for each of the three years ended December 31:
The Company did not change its methodology or key assumptions used in 2004, 2003 or 2002 to determine ultimate loss reserves for any line of insurance business written.
During 2004, the Segment’s net adverse development of $292 million was driven primarily by increases in reported case reserves for excess professional liability, excess casualty liability and specialty lines. These increases in reported case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Strengthening of $122 million in professional lines was caused by a few large directors’ and officers’ claims in pre-2002 business, while increases in errors and omisions reserves were caused by loss related to large accounting firms and insurance and reinsurance brokers. For specialty lines, strengthening of $152 million was caused by reported loss
During 2003, the Company’s net adverse prior year development of $153 million was due primarily to increases in previously reported case reserves for excess professional liability lines of $143 million for the underwriting years 1997 through 2001. These increases in reported case reserves exceeded the Company’s expected losses based on historical patterns of loss development. Specifically, the increase related to reported case reserves for directors’ and officers’ and errors and omissions coverages. During 2003, there was an increase in the amount of litigation related to certain losses.
During 2004 and 2003, the Company’s net adverse development of its gross reserves greatly exceeded its net reserve adverse development due principally to an increase in prior year reserves related to Winterthur International. The Company has protection with respect to any adverse loss or premium development related to the acquired Winterthur International operations with effect from July 1, 2001 under the SPA with the Seller, and has recorded a recoverable of the same amount. See - Liquidity and Capital Resources and Item 8, Note 5(b) to the Consolidated Financial Statements for further information.
During 2002, the Company’s net adverse prior year development of $28 million was comprised of an increase in loss reserves of $73 million relating to the September 11 event which was partially offset by a net decrease in the other reserves of $45 million.
The underwriting expense ratio for the year ended December 31, 2004 compared to the same period in 2003 increased slightly. The decrease in the acquisition expense ratio of 1.6 points (13.3% as compared to 14.9%) was offset by an increase in the operating expense ratio of 1.8 points (13.1% as compared to 11.3%). The reduction in the acquisition expense ratio was due primarily to a change in the mix of business earned compared to the same period in the prior year and changes in the commission structure with certain brokers. The increase in the operating expense
ratio was due primarily to the increased costs associated with supporting new business growth in the segment operations globally, including start up operations, an allocation of certain corporate expenses to the insurance segment and the impact of foreign exchange movements.
The decrease in the underwriting expense ratio in 2003 from 2002 was due to a reduction in the acquisition expense ratio of 2.0% (14.9% as compared to 16.9%) and a reduction in the operating expense ratio of 2.1% (11.3% as compared to 13.4%). The reduction in the acquisition expense ratio was due primarily to lower commission and brokerage costs in a favorable underwriting market on certain lines of business and where there has been a change in the mix of business earned. The reduction in the operating expense ratio was due to the growth in net premiums earned where the amount of net premiums earned was increased more than the amount of increase in operating expenses, which was due primarily to the growth in the insurance segment operations.
The decrease in the loss and loss expense ratio for the year ended December 31, 2004 compared to 2003 was primarily due to the fact that 2003 included significant adverse prior period development related to the Company’s North American casualty business. See further discussion below. The segment experienced losses in 2004 resulting from hurricanes Charley, Frances, Ivan and Jeanne, from which the segment incurred a combined $268.3 million of net losses and loss expenses. In addition, the segment incurred net losses and loss expenses of $24.6 million as a result of the earthquake and tsunami in South Asia. These large catastrophe losses contributed 10.0% to the segment loss ratio for the year ended December 31, 2004. Catastrophe losses were partially offset by lower than expected incurred loss development in the year relating to shorter tail lines prior underwriting years and price improvements on earned premiums from prior periods.
The loss and loss expense ratio increased in 2003 as compared to 2002 due primarily to net adverse development of prior year loss reserves related to the Company’s North American casualty business written during the 1997 through 2001 underwriting years. See further discussion below.
by $32 million for Enron, Worldcom and Laddering claims. The accident & health reserve strengthening of $45 million relates to a portfolio of business underwritten by certain of the Company’s Lloyds syndicates.
In the fourth quarter of 2003, the Company reduced aviation loss reserves related to the September 11 event by $197 million. This reduction in reserves was due to higher than expected levels of participation (97%) in the September 11 Victim Compensation Fund, a no-fault compensation scheme funded by the U.S. government, which closed on December 22, 2003. This resulted in a reduction of the estimated ultimate losses by the Company for this event.
In the second quarter of 2002, the segment increased its estimated loss reserves for the September 11 event by $127 million due primarily to higher than originally estimated business interruption losses and exposure to potential claims by the Lloyd’s Central Guaranty Fund. The increase followed an analysis of additional new information received from the Company’s ceding companies with regard to their increased estimates of claims relating to their exposures to the September 11 event. Due to the size and complexity of the loss and the time lag in ceding companies reporting the information to the segment, establishing reserves for this loss within a short time period was difficult.
The segment’s reserving process includes a continuing evaluation of the potential impact on unpaid liabilities from exposure to asbestos and environmental claims, including related loss adjustment expenses. Liabilities are established to cover both known and incurred but not reported claims.
The Company reviews its actual reported loss experience for asbestos and environmental claims for its 1985 and prior exposures annually. The actual loss experience was consistent with assumptions established, and, therefore, there was no adverse prior year development of the Company’s asbestos and environmental reserves in 2003 or 2004. The reserves for these exposures represented less than 1% of the Company’s total unpaid loss and loss expense reserves at December 31, 2004.
The decrease in the underwriting expense ratio for the year ended December 31, 2004 as compared with 2003 was primarily due to a decrease in acquisition cost ratio driven by reduced profit commissions as a result of the year’s catastrophic losses. This decrease was partially offset by an increase in the operating expense ratio resulting from additional allocations of corporate expenses as well as the adverse impact of foreign exchange and the continued build up of the European reinsurance platform. The increase in the underwriting expense ratio in 2003 as compared with 2002 was due to an increase in the acquisition expense ratio of 0.8% and operating expense ratio of 0.9%. The increase in the acquisition expense ratio was due primarily to higher ceding company profit commissions payable and a change in the mix of net premiums earned. The operating expense ratio increased due primarily to a reduction of operating expenses in 2002 of approximately $8.0 million in recognition of a curtailment gain on a Company pension plan in the U.S.
Exchange gains in 2004 and 2003 were mainly attributable to a decline in the value of the U.S. dollar against U.K. sterling and the Euro in Bermuda based operations that write business globally.
Life and annuity gross and net premiums written, net premiums earned and claims and policy benefits in each of the three years ended December 31, 2004, 2003 and 2002 included the assumption of the following long duration annuity portfolios:
large upfront premium contracts written. Market conditions are being driven by credit spread compression, higher interest rates, increased competition and reduced public financing. Gross and net premiums written increased in 2003 compared to 2002 reflecting an increase in the volume of insured debt obligations, enhanced market penetration by the Company’s financial guaranty platform, and expansion of the platform into the public finance market.
Net investment income related to the financial guaranty business increased in 2004, as compared to 2003, due to the larger investment portfolio created by growth in premium receipts and a $100.0 million capital infusion to this business in the fourth quarter of 2003. Net investment income related to the financial guaranty business decreased in 2003, as compared to 2002, due primarily to a decline in general market interest rates.
The net realized and unrealized positions on weather and energy risk management derivative instruments resulted in a small gain for the years ended December 31, 2004 and 2003. The gain in 2004 was the result of gains in the weather portfolio due to warm temperatures late in the year, partially offset by losses due to higher than expected temperature volatility in the first half of the year and costs associated with exiting natural gas positions. During 2004
the positions and activities in the gas area were significantly reduced, those in the weather area have been increased slightly, and new contingent risk products were introduced.
ing agreements in the second quarter of 2003 combined with increases in the average balances outstanding related to the book of municipal reinvestment contracts. The balances outstanding for funding agreements and municipal reinvestment contracts increased from $0.6 billion and $1.5 billion, respectively, as at December 31, 2003 to $1.1 billion and $2.6 billion, respectively, as at December 31, 2004.
Net income from investment affiliates in 2004 reflects the twelve months to November 30, 2004, as compared to the eleven months ended November 30, 2003 in 2003 and the twelve months ended December 31, 2002 in 2002. The Company records the investment affiliates on a one month lag in order for the Company to meet the accelerated filing deadlines as specified by the SEC.
Net investment income related to general operations increased in 2004 as compared to 2003 primarily due to growth in the investment base, as well as moderate increases in the yield of the portfolio.
The Company’s total investments available for sale and cash and cash equivalents less net pending payable for investments purchased was $29.9 billion at December 31, 2004 as compared to $23.1 billion at December 31, 2003. This increase of $6.8 billion includes (i) cash flow from operations of $4.4 billion and (ii) cash flow of $1.5 billion from spread product transactions. The annualized effective yield of the total investment portfolio was 3.8% for 2004 as compared to 3.5% for 2003, a 0.3% increase. The increase in the effective yield of the total investment portfolio was primarily due to general interest rate increases in the U.S., and the growth in assets invested in non-U.S. markets, particularly the United Kingdom, where investment grade yields are generally higher than in the U.S.
Net investment income related to general operations decreased in 2003 as compared to 2002 primarily due to the market decline in yields and the shorter duration of the investment portfolio, partially offset by growth in the investment base.
Portfolio returns are calculated by dividing the sum of the net investment income, realized gains (loss) and unrealized gains, (loss) by the daily weighted average market value of each portfolio.
In 2004, net realized gains on investments were $246.5 million which includes $265.9 million of gross realized losses on fixed income and $48.8 million of gross realized losses on equity securities. Gross realized losses in 2004 included $6.4 million of provisions for declines in fair value considered to be other than temporary. In the United States there was a general reduction in the level of corporate defaults. For example, Moody’s Investor Service (“Moody’s”) reported that 57 issuers defaulted in 2004 as compared with 77 issuers in 2003 and 141 issuers in 2002. The Company’s exposure to these defaults was even more limited in 2004 resulting in a significant reduction in the write down for other than temporary declines. Of the write-downs in 2004, 50% related to credit impairments within the airlines industry. As a percentage of the total fixed income portfolio, the write down for other than temporary declines was negligible in 2004 as compared with 0.6% in 2003 and 1.6% in 2002.
During the year ended 2002, the Company had net realized losses on investments of $214.2 million. This included gross realized losses on fixed income and equity securities of $526.3 million and $160.1 million, respectively. Gross and net realized losses in 2002 included $251.5 million of provisions for declines in fair value considered to be other than temporary. Of the total provisions, $144.3 million related to fixed income securities, $77.8 million to equity securities and $29.4 million to other investments. Approximately 44% of the declines in fair value in 2002 of fixed income and equity securities considered to be other than temporary related to the communications sector, including Worldcom Inc. and Adelphia Communication Corp. in the second quarter of 2002. In addition, approximately $41.0 million of gross realized losses related to sales of Worldcom Inc. and Adelphia Communication Corp.
The significant circumstances that contributed to the realized losses in 2002 included the high level of distress and default in the telecommunications sector, the Enron Corp. bankruptcy and a general rise in corporate defaults across other sectors in response to the general economic decline in the United States and elsewhere.
With respect to those securities that were sold at a loss during the year ended December 31, 2003 the following is an analysis of the period of time that those securities had been in a continual unrealized loss position, the amount of the realized loss recorded in the Company’s results of operations as of the sale date and the amount of the impairment charge taken in the year:
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.”
Net realized and unrealized gains on investment derivatives result from the Company’s investment strategy to economically hedge against interest and foreign exchange risk within the investment portfolio. See
FOR THE YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 (Continued)
Reinstatement premiums are recognized at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are earned on a pro-rata basis over the remaining risk period.
In the normal course of business, the Company seeks to reduce the potential amount of loss arising from claims events by reinsuring certain levels of risk assumed in various areas of exposure with other insurers or reinsurers. Reinsurance premiums ceded are expensed (and any commissions recorded thereon are earned) on a monthly pro-rata basis over the period the reinsurance coverage is provided. Prepaid reinsurance premiums represent the portion of premiums ceded applicable to the unexpired term of policies in force. Reinstatement premiums ceded are recorded at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are expensed over the remaining risk period. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Provisions are made for estimated unrecoverable reinsurance.
Fee income and other includes fees received for insurance and product structuring services provided and is earned over the service period of the contract. Any adjustments to fees earned or the service period are reflected in income in the period when determined.
an analysis of the liquidity, business prospects and overall financial condition of the issuer, (iii) the significance of the decline, (iv) an analysis of the collateral structure and other credit support, as applicable, of the securities in question and (v) the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company concludes that declines in fair values are other than temporary, the cost of the security is written down to fair value below carrying value and the previously unrealized loss is therefore realized in the period such determination is made.
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed benefit (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities, as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated and recorded at fair value with changes in fair value recognized in earnings.
Short-term investments comprise investments with a maturity equal to or greater than 90 days at the time of purchase but less than one year. Equity securities include investments in open end mutual funds.
Investments in which the Company has significant influence over the operating and financial policies of the investee are classified as investments in affiliates on the Company’s balance sheets and are accounted for under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in its results for the period. Significant influence is deemed to exist where the Company has an investment of 20% or more in the common stock of a corporation or an investment of 3% or greater in closed end funds, limited partnerships or similar investment vehicles. Significant influence is considered for other strategic investments on a case-by-case basis. The determination of whether an entity is classified as an affiliate for GAAP
accounting purposes may be different from the determination of whether such entity would constitute an affiliate for any other purposes, including regulatory purposes. The income from affiliates is shown separately between income from operating affiliates and net income from investment affiliates. Any decline in value of an affiliate investment considered by management to be other than temporary is charged to income in the period that it is determined.
Other monetary assets and liabilities denominated in foreign currencies are revalued at the exchange rate in effect at the balance sheet date and revenues and expenses are translated at the exchange rate on the date the transaction occurs with the resulting foreign exchange gains and losses recognized in income.
Unpaid losses and loss expenses includes reserves for reported unpaid losses and loss expenses and for losses incurred but not reported. The reserve for reported unpaid losses and loss expenses for the Company’s general and financial operations is established by management based on amounts reported from insureds or ceding companies, and represents the estimated ultimate cost of events or conditions that have been reported to or specifically identified by the Company.
to fund expected future payment obligations (this is equivalent to the ‘best estimate’ of future cash flows), which are determined actuarially based upon the nature of the underlying indemnifiable losses. Accretion of the liability is recorded as interest expense. The Company periodically reassesses the estimated ultimate liability. Any changes to this liability are reflected as adjustments to interest expense to reflect the cumulative effect of the period the contract has been in force, and by an adjustment to the future accretion rate of the liability over the remaining estimated contract term.
The Company accounts for stock compensation plans in accordance with the fair value recognition provisions of FAS 123 “Accounting for Stock-Based Compensation”, This method was adopted as of January 1, 2003 using the prospective method allowed under FAS 148, “Accounting for Stock-Based Compensation - Transition and
Basic earnings per ordinary share is based on weighted average ordinary shares outstanding and excludes any dilutive effects of options and convertible securities. Diluted earnings per ordinary share assumes the exercise of all dilutive stock options and conversion of convertible securities where the contingency for conversion has occurred or been satisfied.
In March 2004, the FASB ratified Emerging Issues Task Force (“EITF”) Issue No. 03-16, “Accounting for Investments in Limited Liability Companies” (the “Issue”). In EITF Abstracts, Topic No. D-46, “Accounting for Limited Partnership Investments,” the SEC staff clarified its view that investments of more than three to five percent are considered to be more than minor and, therefore, should be accounted for using the equity method. Limited liability companies (“LLCs”) have characteristics of both corporations and partnerships, but are dissimilar from both in certain respects. Due to those similarities and differences, diversity in practice exists with respect to accounting for noncontrolling investments in LLCs. This Issue addresses whether an LLC should be viewed as similar to a corporation or similar to a partnership for purposes of determining whether a noncontrolling investment should be accounted for using the cost method or the equity method of accounting. The EITF reached a consensus that an investment in an LLC that maintains a “specific ownership account” for each investor, similar to a partnership capital account structure should be viewed as similar to an investment in a limited partnership for purposes of determining whether a noncontrolling investment in an LLC should be accounted for using the cost method or the equity method. This EITF applies to all investments in LLCs and is effective for reporting periods beginning after June 15, 2004. The adoption of this Issue did not have a material effect on the Company’s financial condition or results of operations.
Statement of Position (“SOP”) 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an
investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. This SOP limits the yield that may be accreted (accretable yield) to the excess of the investor’s estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the investor’s initial investment in the debt security. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The adoption of the SOP is not expected to have a material effect on the Company’s financial condition or results of operations.
General 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, integrated risk 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, surety, specie, bloodstock and other insurance including program business.
This includes net realized gains on investments of $246.5 million and net realized and unrealized gains on
The following table shows an analysis of intangible assets broken down between goodwill, intangible assets with an indefinite life and intangible assets with a definite life for the years ended December 31, 2004, 2003 and 2002:
Amortization of intangible assets includes $1.9 million related to an acquired block of business expensed through acquisition costs
The cost of the acquisition for the increase in ownership from 49% to 67% in 2002 was approximately $188.5 million. Goodwill arising from the acquisition was approximately $52.6 million. The Company recognized goodwill in excess of the fair value of XL Re Europe’s net assets to increase its European franchise for its reinsurance operations. Cash paid, net of cash acquired, was $45.5 million during the year ended December 31, 2002.
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (“Winterthur International”) primarily to extend its predominantly North American based large corporate insurance business globally. The Company provisionally paid to Winterthur Swiss Insurance Company (the “Seller”) $405.6 million at closing for Winterthur International based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at December 31, 2000 and the price was subject to final determination based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at June 30, 2001. In December 2003, the Company reached an agreement with the Seller as to the final purchase price, which was $330.2 million. As a result, $75.4 million in cash was returned to the Company.
At December 31, 2004, certain reinsurers responsible for some portions of the reinsurance of the Winterthur Business have raised issues as to whether amounts claimed are due and the resolution of those discussions is also currently ongoing.
The acquisition was accounted for under the purchase method of accounting and, therefore, the identifiable assets and liabilities of Winterthur International were recorded at their estimated fair value on June 30, 2001. The process of determining the fair value of such assets and liabilities acquired, as required under purchase accounting, included management’s estimates and independent valuations. The purchase price was preliminarily allocated to the acquired assets and liabilities based upon their estimated fair value at June 30, 2001. The excess of the purchase price over acquired tangible net assets was then applied to intangible assets with finite and indefinite lives. With the settle-
The following represents an analysis of net realized gains (losses) and the change in unrealized appreciation on investments:
Net realized gains and losses in 2004 and 2003 included a loss of $6.4 million and $130.7 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 2003 related to $68.4 million on fixed income securities, $54.2 million on equity securities and $8.1 million on other investments. Of the decline in value of fixed income and equity securities considered to be other than temporary in 2003, approximately 12% related to investments in the communications sector.
At December 31, 2004 and 2003, approximately $100.0 million and $418.4 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, 2004 and 2003, approximately $102.0 million and $426.5 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.
The Company has invested in certain closed end funds, certain limited partnerships and similar investment vehicles, including funds managed by certain of its investment management affiliates. At December 31, 2004, investment affiliates was $1.7 billion of which $1.5 billion was included in the alternative investment portfolio and $0.2 billion consisted of private investments. At December 31, 2003, investment affiliates was $1.6 billion of which $1.4 billion was included in the alternative investment portfolio and $0.2 billion consisted of private investments.
The Company’s significant financial affiliate investments at December 31, 2004 included Primus Guaranty, Ltd. with ownership of 33%.
The Company’s insurance affiliate investments at December 31, 2004 included Sovereign Risk Insurance, American Strategic Holdings, and Special Risks Insurance and Reinsurance with ownership in those entities at 50%, 49%, and 18%, respectively.
The significant investment management affiliates include Highfields Capital Management LP, a global equity investment firm, MKP Capital Management, a fixed income investment manager, specializing in mortgage-backed securities, FrontPoint Partners LLC, an integrated alternative asset firm, Stanfield Capital Partners, a credit based asset management firm and Banquo Credit Management LLC, a European credit based asset management firm. During the year, the Company sold its interest in Pareto Partners L.P. and its affiliated entities, a currency overlay and fixed income manager, resulting in income of $35.4 million.
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 debt/equity instruments. Income from other investments was $16.2 million and $6.6 million for the years ended December 31, 2004 and 2003, respectively. Unrealized gains from other investments was $4.4 million and $2.7 million as at December 31, 2004 and 2003 respectively. Income on unrated tranches of collateral debt obligations is reflected only to the extent the Company’s principal has been fully recovered. Income on alternative investments included in other investments is realized only on ultimate sale of these investments. The Company had unrealized gains of $7.3 and nil, respectively, at December 31, 2004 and 2003, related to these alternative investments.
The Company recorded losses of $0.4 million and $8.1 million in the years ended December 31, 2004 and 2003, respectively, due to other than temporary declines in values of these investments.
insurance/reinsurance brokers. For specialty lines, strengthening of $135 million was caused by reported loss increased in discontinued Programs business with workers’ compensation exposure environmental related coverages, and Lloyds; as well as high severity claims on the Surety book.
During 2004, net prior year reserves across the Reinsurance Segment developed favorably by $24 million. Releases of $144 million net in the property, aviation, marine and other lines of business were partially offset by strengthening of casualty and accident and health reserves amounted to approximately $120 million. Property catastrophe and property other reserve releases totaled approximately $95 million net related primarily to the 2002 and 2003 underwriting years where loss experience has been exceptionally good for the Property line. The strengthening of casualty reserves totaled $75 million and related most significantly to professional liability reserves in the London branch which were strengthened by $32 million for Enron, Worldcom and Laddering claims. The accident & health reserve strengthening of $45M relates to a portfolio of business underwritten by certain of the Company’s Lloyds syndicates
In the fourth quarter 2003, the Company reduced aviation loss reserves related to the September 11 event by $197.0 million. This reduction was due to higher than expected levels of participation (97%) in the September 11 Victim Compensation Fund, a no-fault compensation scheme funded by the U.S. government which closed on December 22, 2003. This resulted in a reduction in the estimated ultimate losses by the Company for this event.
The increase in estimate for all other reinsurance reserves in 2002 of $258 million also related principally to losses on business written in 1997 through (and including) 2000 in the Company’s U.S. casualty reinsurance business and for asbestos losses in years prior to 1985. The increase in 2002 was partially offset by decreases in estimates for losses related to business written in 1985 through 1996 in these same lines of business. The increase in 2002 was also due to increases in reported claims that were in excess of the Company’s expected loss development for this business from higher court settlement awards. The Company did not change its methodology or key assumptions for determining ultimate loss reserves in 2002.
The nature of the Company’s high excess of loss liability and catastrophe business can result in loss payments that are both irregular and significant. Similarly, adjustments to reserves for individual years can be irregular and significant. Such adjustments are part of the normal course of business for the Company. Conditions and trends that have affected development of liability in the past may not continue in the future. Accordingly, it is inappropriate to extrapolate future redundancies or deficiencies based upon historical experience.
Incurred but not reported losses, net of reinsurance, included in the above table was $22.5 million in 2004, $27.0 million in 2003 and $33.1 million in 2002. Unpaid losses recoverable are net of potential uncollectible amounts.
As of December 31, 2004, the Company had approximately 832 open claim files for potential asbestos exposures and 446 open claim files for potential environmental exposures on business written prior to 1986. Approximately 49% of the open claim files in 2004 and 43% in 2003 are due to precautionary claim notices. Precautionary claim notices are submitted by the ceding companies in order to preserve their right to receive coverage under the reinsurance contract. Such notices do not contain an incurred loss amount to the Company. The development of the number of open claim files for potential asbestos and environmental claims is as follows:
At December 31, 2004, net losses and loss expenses comprise gross claims of $1.9 billion with estimated reinsurance recoveries of $1.1 billion. The Company has paid approximately 67% of its estimated ultimate net losses related to the September 11 event as at December 31, 2004.
The following table presents an analysis of total unpaid losses and loss expenses recoverable between general, life and annuity, and financial operations for the year ended December 31:
At December 31, 2004, the total reinsurance assets of $7.8 billion include reinsurance recoverables for paid losses and loss expenses of $1.1 billion and $6.7 billion with respect to the ceded reserve for losses and loss expenses, including ceded losses incurred but not reported. Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is based on specific contract provisions, the collectibility of such amounts requires significant estimation by management. The majority of the balance we have accrued as recoverable will not be due for collection until sometime in the future. Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and while they may continue to acknowledge their contractual obligation to do so, they may not have the financial resources or willingness to fully meet their obligation to the Company.
At December 31, 2004, the provision for uncollectible reinsurance was $279 million. To estimate this provision, the reinsurance recoverable must first be allocated to applicable reinsurers. This determination is based on a process rather than an estimate, although an element of judgment must be applied. As part of this process, ceded IBNR is allocated by reinsurer. The allocations are generally based on historical relationships between gross and ceded losses. If actual experience varies materially from historical experience, the allocation of reinsurance recoverable by reinsurer will change.
At December 31, 2004, the use of different assumptions within the model could have a material effect on the bad debt provision reflected in the Company’s Consolidated Financial Statements. To the extent the creditworthiness of the Company’s reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than the Company’s bad debt provision. Such an event could have a material adverse effect on the Company’s financial condition, results of operations, and liquidity.
Included in unpaid loss and loss expenses recoverable at December 31, 2004 from general operations is an unsecured reinsurance recoverable from Winterthur Swiss Insurance Company (currently rated A by Standard and Poor’s) of $1.45 billion related to the acquisition of Winterthur International. Also, of the total unpaid loss and loss expense recoverable and reinsurance balances receivable at December 31, 2004 of $7.8 billion, approximately $2.0
billion related to Winterthur International and these recoverable balances are also guaranteed by Winterthur Swiss Insurance Company. See Note 5(b).
During 2004 and 2003, the Company entered into long duration contracts that subject the Company to mortality and morbidity risks and which were accounted for as life premiums earned. Future policy benefit reserves were established using appropriate assumptions for investment yields, mortality, and expenses, including a provision for adverse deviation. The average interest rate used for the determination of the future policy benefits for these contracts was 5.1% and 5.2% at December 31, 2004 and 2003, respectively. Total future policy benefit reserves for the year ended December 31, 2004 and 2003 were $4.5 and $3.2 billion, respectively. Substantially all of these reserves relate to closed blocks of annuities.
As at December 31, 2004, the Company had bank, letter of credit and loan facilities available from a variety of sources, including commercial banks, totaling $7.8 billion, (2003: $6.1 billion) of which $2.7 billion (2003: $1.9 billion) of debt was outstanding. In addition, $3.0 billion (2003: $2.7 billion) of letters of credit were outstanding as at December 31, 2004, 6.6%, (2003: 8.7%) of which were collateralized by the Company’s investment portfolio, supporting U.S. non-admitted business and the Company’s Lloyd’s Syndicates’ capital requirements.
In September 2004, the Company created a new $100 million unsecured bilateral credit facility that was unutilized during 2004 and at December 31, 2004. Of the aggregate amount of $100 million, $60 million is available as revolving credit and up to $100 million is available in the form of letters of credit, with the combined total not to exceed $100 million.
In August 2004, the Company issued the first tranche of $300 million aggregate principal amount of 5.25% Senior Notes due September 2014. The bonds were issued at 99.432% and gross proceeds were $298.3 million. Related expenses of the offering amounted to approximately $1.7 million. Proceeds of these notes were used to redeem the Liquid Yield Option Notes (“LYONs”), as described below.
costs associated with the issuance of the Units, $23.7 million was charged to “Additional paid in capital” with the remainder deferred and amortized over the term of the senior debt. The number of ordinary shares to be issued under each purchase contract depends on, among other things, the average market price of the ordinary shares. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 11 million. The Company accounts for the effect on the number of weighted average ordinary shares, assuming dilution, using the treasury stock method. The purchase contract component of the Units will have no effect on the number of weighted average ordinary shares, assuming dilution, except when the average market price of the Company’s ordinary shares is above the threshold appreciation price of $93.99 per share. Because the average market price of the Company’s ordinary shares during the period the Units were outstanding was below this price, the shares issuable under the purchase contracts were excluded from the computation of net income per ordinary share assuming dilution for the three and twelve month periods ended December 31, 2004.
In July 2003, the Company entered into a contingent capital transaction with an aggregate value of $500.0 million. This transaction also provides the Company with an insurance trust that provides the Company with statutory relief under state insurance regulations in the U.S. Under the terms of this facility, the Company has acquired an irrevocable put option to issue preference ordinary shares into a trust in return for proceeds raised from investors. This put option may be exercised by the Company at any time. In addition, the Company may be required to issue preference ordinary shares to the trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a ratings downgrade of the Company. In connection with this transaction, the fair value of the put premiums and other related costs, in total of $109.9 million was charged to “Additional Paid in Capital” and a deferred liability was established (included with “Other liabilities”) of $102.5 million in the Consolidated Balance Sheet at December 31, 2003. The Company began to amortize this liability that resulted in additional interest expense of approximately $3.5 million in 2004 and $2.0 million in 2003 and the liability will continue to be amortized over a ten year term.
In September 2001, the Company issued $508.8 million principal amount at maturity (subsequently increased to $514.6 million under the provisions of an upward interest adjustment provision) of LYONs. The accretion rate on the LYONs was originally 2.875% per annum on a semi-annual basis or 2.896% per annum on an annual basis. The accretion rate for the year to September 7, 2004, was increased by 0.645% per annum on a semi-annual basis to 3.52% on a semi-annual basis and 3.551% per annum on an annual basis as a result of the of the Company’s ordinary share price in the 30-day period leading up to the second put date in September 2003. On September 7, 2004, the Company redeemed the entire issue of LYONs at their accreted value of approximately $317 million, using proceeds from the issuance of the first tranche of Senior Notes due 2014, as described above.
During 1995, the Company issued $100.0 million of 7.15% Senior Notes due November 15, 2005 through a public offering at a price of $99.9 million.
The Company has several letter of credit facilities provided on a syndicated and bilateral basis from commercial banks. These facilities are utilized to support non-admitted insurance and reinsurance operations in the U.S. and capital requirements at Lloyd’s. The commercial facilities are scheduled for renewal during 2005 and 2007. In addition to letters of credit, the Company has established insurance trusts in the U.S. that provide cedents with statutory relief required under state insurance regulation in the U.S. It is anticipated that the commercial facilities will be renewed on expiry but such renewals are subject to the availability of credit from banks utilized by the Company. In the event that such credit support is insufficient, the Company could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by the Company’s investment portfolio or funds withheld using the Company’s cash resources. The value of letters of credit required is driven by, among other things, loss development of existing reserves, the payment pattern of such reserves, the expansion of business written by the Company and the loss experience of such business.
In 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 (other than its “AAA” financial guaranty companies) 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, 3-year credit facility, five-year credit facilities and 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 the Company’s insurance and reinsurance rated operating subsidiaries (other than its “AAA” financial guaranty companies) fail to maintain a rating of at least “A” from S&P, an event of default would occur. The Company currently has an “A+ under review” rating from A.M. Best and “AA-” from S&P.
ology. Under this methodology, the fair value is determined using a cash flow model developed by the Company which is dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. In general, the Company holds credit derivatives to maturity. Accordingly, changes in the fair value of such credit derivatives are unrealized. For the years ended December 31, 2004, 2003, and 2002 the change in the fair value of credit derivatives issued in connection with the Company’s financial guaranty business was a gain of $52.9 million, a loss of $25.8 million, and a loss of $46.1 million, respectively.
At December 31, 2003, contracts designated as fair value and cash flow hedges were in a $3.2 million net unrealized gain position. As a result of the fair value hedges, deposit liabilities were increased by $3.1 million at December 31, 2003. The ineffective portion of the hedge amounted to $0.1 million as part of net realized gains. The interest rate swap hedges resulted in a reduction in interest expense of $2.6 million for the year ended December 31, 2003.
In August 2004, the Company entered into a treasury rate guarantee agreement in anticipation of the issuance of fixed-rate debt. 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 $300.0 million of 5.25% Senior Notes due September 15, 2014 (see Note 8 above). The loss on the settlement of the treasury rate guarantee transaction on August 18, 2004 of $6.3 million was charged to Accumulated Other Comprehensive Income and is being amortized to interest expense over the 10-year term of the related debt.
In 2002, the Company entered into a treasury rate lock agreement with the underwriters of the 6.50% Guaranteed Senior Notes due 2012 (2001: 6.58% Guaranteed Senior Notes due 2011). The Notes were priced using a margin over the yield of a U.S. Treasury note with a similar maturity. The treasury rate lock agreement was designed to eliminate underlying pricing risk of the Company’s debt that would have resulted from an increase in the yield of the comparable U.S. Treasury issue between the initiation of the transaction and the pricing of the transaction. The total cost of the hedge was $4.2 million. In 2001, a loss of $5.6 million was recorded in net realized and unrealized gains and losses related to the cancellation of the treasury lock agreement relating to the 6.58% notes due 2011 due to the September 11, 2001 event
The Company also uses bond and stock index futures to add value to the portfolio where market inefficiencies are believed to exist, to equitize cash holdings of equity managers and to adjust the duration of a portfolio of fixed income securities to match the duration of related deposit liabilities. These instruments are marked to market on a
The Company also has investment related derivatives embedded in certain reinsurance contracts. For a particular life reinsurance contract, the Company pays the ceding company a fixed amount equal to the estimated present value of the excess of guaranteed benefit (“GMIB”) over the account balance upon the policyholder’s election to take the income benefit. The fair value of this derivative is determined based on the present value of expected cash flows. In addition, the Company has modified coinsurance and funds withheld reinsurance agreements that provide for a return based on a portfolio of fixed income securities, as such, the agreements contain embedded derivatives. The embedded derivative is bifurcated from the funds withheld balance and recorded at fair value with changes in fair value recognized in earnings.
In December 2004, XLFA entered into a put option agreement and an asset trust expense reimbursement agreement with the Asset Trust. The put option agreement provides XLFA with the irrevocable right to require the Asset Trust at any time and from time to time to purchase XLFA’s non-cumulative perpetual Series B Preferred Shares with an aggregate liquidation preference of up to $200 million. XLFA is obligated to reimburse the Asset Trust for certain fees and ordinary expenses. To the extent that any Series B Preferred Shares are put to the Asset Trust and remain outstanding, a corresponding portion of such fees and ordinary expenses will be payable by XLFA pursuant to the asset trust expense reimbursement agreement. The put option agreement is perpetual but would terminate on delivery of notice by XLFA on or after December 9, 2009, or under certain defined circumstances, such as the failure of XLFA to pay the put option premium when due or bankruptcy. The put option is recorded at fair value with changes in fair value recognized in earnings.
The Company has an investment in the junior notes of a collateralized debt obligation (“CDO”). The Company also issued financial guaranties for the senior notes of the CDO. As of December 31, 2004, the CDO had assets of $468.2 million and liabilities of $395.6 million and the Company’s maximum exposure to loss as a result of its financial guaranties and investment in this variable interest entity was approximately $412.3 million. The Company could experience a loss in the event that the cash flows relating to the underlying assets are not collected as expected. The Company is not the primary beneficiary of this entity and therefore is not required to consolidate this entity.
Other includes Canada, France, Germany, Korea, Chile, Australia, Japan, Portugal, El Salvador, Jamaica, Panama, Costa Rica, Qatar, New Zealand and Spain.
The areas where significant concentrations of credit risk may exist include unpaid losses and loss expenses recoverable and reinsurance balances receivable (collectively “reinsurance assets”), investments and cash and cash equivalent balances. The Company’s reinsurance assets at December 31, 2004 amounted to $7.8 billion and resulted from reinsurance arrangements in the course of its operations. A credit exposure exists with respect to reinsurance assets as they may be uncollectible. The Company manages its credit risk in its reinsurance relationships by transacting with reinsurers that it considers financially sound, and if necessary, the Company may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
On July 25, 2001, the Company completed the acquisition of certain Winterthur International insurance operations (“Winterthur International”) primarily to extend its predominantly North American based large corporate insurance business globally. The Company provisionally paid to the Seller $405.6 million at closing for Winterthur International based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at December 31, 2000 and the price was subject to final determination based on the audited U.S. GAAP financial statements of the acquired Winterthur International operations as at June 30, 2001. In December 2003, the Company reached an agreement with the Seller as to the final purchase price, which was $330.2 million. As a result, $75.4 million in cash was returned to the Company.
At the time of the Winterthur International acquisition, the seller provided to the Company a liquidity facility. At the time of the payment of the net reserve seasoned amount as described above. The Company has the right to repay up to the balances outstanding on this facility by assignment to the Seller of an equal amount of receivables relating to reinsurance recoverables selected by the Company. The payable balance related to this facility is included within other liabilities on the Company’s balance sheet at December 31, 2004 and amounted to approximately $281 million at that date.
Under two retrocession agreements the Company has reinsurance protection on the remaining portion of reinsurance recoverables with respect to incurred losses seasoned as of June 30, 2004 to the extent that the Company does not receive payment of such amounts from applicable reinsurers with one agreement providing a limit of $1.3 billion for the insurance written in the period to June 30, 2001 and the other agreement providing a limit of $1.3 billion for the insurance written in the period to December 31, 2000.
At December 31, 2004, certain reinsurers responsible for some portions of the reinsurance of the Winterthur business have raised issues as to whether amounts claimed are due and the resolution of those discussions is also currently ongoing.
There is deterioration of the net reserves and premium balances, relating to the Winterthur Business, from what is reported in the Company’s December 31, 2004 financial statements
The Company owns a minority interest in certain closed-end funds, certain limited partnerships and similar investment vehicles, including funds managed by those companies. The Company has commitments, which include potential additional add-on clauses, to invest a further $50.6 million over the next five years.
In November 2002, the Company issued 11.5 million 7.625% Series B Preference Ordinary Shares at $25 per share. Gross proceeds were $287.5 million and related expenses were $9.1 million. Upon dissolution of the Company, the holders of the Preference Shares would be entitled to receive a liquidation preference of $25 per share, plus accrued and unpaid dividends. Dividends on the Preference Shares are cumulative from the date of original issuance and are payable when declared. The Company may redeem the Preference Shares on or after November 18, 2007, at a redemption price of $25 per share. The Company may, under certain circumstances, redeem the Preference Shares before November, 2007 at specified redemption prices, plus accrued and unpaid dividends. These circumstances include an amalgamation, consolidation or other similar transaction involving the Company in which the Preference Shares are entitled to a class vote ($26 per share redemption price), or a change in tax laws that requires the Company to pay additional amounts with respect to the Preference Shares ($25 per share redemption price). The proceeds were used for general corporate purposes.
Prior to December 31, 2003, all options granted to non-employee directors were granted under the 1991 Performance Incentive Program. In 2004, these options were granted under the Directors Stock & Option Plan. All options vest immediately on the grant date. Directors may also make an irrevocable election preceding the beginning of each fiscal year to defer cash compensation that would otherwise be payable as his or her annual retainer in increments of 10%. The deferred payments are credited in the form of ordinary share units calculated by dividing 110% of the deferred payment by the market value of the Company’s stock on the date the compensation would otherwise have been paid. These shares are distributed under the terms of the plan. Shares issued under the plan totaled 3,819, 3,153, and 3,622 in 2004, 2003 and 2002, respectively.
A second stock plan is provided for the directors that grants share units equal to their annual retainer divided by market price of the Company’s ordinary stock on January 1 of each year. These units receive dividends in the form of additional units equal to the cash value divided by the market price on the payment date. Stock units totaling 8,351, 8,598, and 6,659 were issued in 2004, 2003 and 2002, respectively. Total units are granted as shares upon retirement from the Board.
Total stock based compensation expensed, which related to amortization of restricted stock, was $28.4 million, $17.9 million, and $14.3 million in 2004, 2003, and 2002, respectively.
The exercise price of the Company’s options granted is the market price of the Company’s Class A ordinary shares on the grant date, except as noted below.
The following options were granted with an exercise price in excess of the market price on the grant date; 295,000 options with an exercise price of $88.00 and the market price was $77.10.
In 2004 and 2003, the Company paid dividends of $40.3 million, respectively, to Series A and Series B preference shareholders.
In 2004, four regular quarterly dividends were paid at $0.49 per share to ordinary shareholders of record as of March 8, June 7, September 6 and December 6.
The Company’s U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the Internal Revenue Code and Regulations there under. Should the U.S. subsidiaries pay a dividend to the Company, withholding taxes will apply.
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2004 and 2003 is provided below:
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2004 and 2003 were as follows:
Except as noted below, there are no statutory restrictions on the payment of dividends from retained earnings by any of the Company’s subsidiaries as applicable minimum levels of solvency and liquidity have been met and all regulatory requirements and licensing rules complied with. At December 31, 2004, and 2003 XL Reinsurance America (“XLRA”), the Company’s lead property and casualty subsidiary in the United States, had a statutory deficit of $84.4 million and $210.3 million, respectively. As a result, XLRA is not currently able to make a dividend distribution under New York insurance law without obtaining prior approval of the New York Insurance Department. Similarly, four of the six property and casualty subsidiaries directly or indirectly owned by XLRA also had statutory deficits ranging from $0.2 million to $57.4 million at December 31, 2004 and five of the six had statutory deficits ranging from $3.6 million to
At December 31, 2004, the Company owned minority stakes in eight independent investment management companies (“Investment Management Affiliates”). These ownership stakes are part of the Company’s asset management strategy, pursuant to which the Company seeks to develop relationships with specialty investment management organizations, generally acquiring an equity interest in the business. The Company also invests in certain of the funds and limited partnerships and other legal entities managed by these affiliates and through these funds and partnerships pay management and performance fees to the Company’s Investment Management Affiliates.
In the third quarter at 2004 the Company recorded net loss and loss expenses of $446.8 million in relation to the 2004 Atlantic hurricane season, which resulted in four insured hurricane aggregating to the largest seasonal loss in history. In the fourth quarter of 2004 that loss estimate was increased by $69.8 million. In addition, the Company incurred net loss and loss expenses of $74.6 million in relation to the tsunami in South Asia in December of 2004.
In the fourth quarter of 2003, the Company completed the claims audit review and its normal year end review of all of its property and casualty reserves and reported a total pre-tax charge of $694.0 million ($647.0 million post tax) related to the following changes to loss reserves :