Total rent expense for the years ended December 31, 2010, 2009 and 2008 was $31.8 million, $34.4 million and $35.4 million, respectively. See Item 8, Note 19(d) to the Consolidated Financial Statements, “Commitments and Contingencies - Properties,” for discussion of the Company’s lease commitments for real property.
In 2008, net loss from operating affiliates includes losses totaling approximately $1.4 billion related to the closing of the Master Agreement as well as losses recorded throughout 2008 and up until the closing of the Master Agreement that were associated with previous reinsurance and guarantee agreements with Syncora. In 2007, $351.0 million of financial guarantee reserves related to reinsurance agreements with Syncora were recorded within net loss from operating affiliates. In 2010, net income from operating affiliates included $50.2 million relating to sale of a majority of the Company’s shareholding in Primus Guaranty Ltd.
The Company has grown through acquisitions and development of new business opportunities. Acquisitions included Global Capital Re in 1997, Mid Ocean Limited in 1998, ECS, Inc. and NAC Re Corp. in 1999, Winterthur International in 2001 and Le Mans Re in 2002. All acquisitions were entered into in order to further support the Company’s strategic plan to develop a global platform in insurance and reinsurance. The Company competes as an integrated global business and at December 31, 2010 employed 3,576 employees in 25 countries. For further information in relation to the Company’s Operations, see Item 1, “Business.”
The following sets forth potential trends relevant to the Company’s property and casualty operations:
Throughout 2009 and 2010 the Company was focused on selective growth initiatives, emphasizing short-tail lines, where applicable, in the Company’s reinsurance operations, exiting other businesses, such as Casualty facultative business and non-renewing certain insurance programs, as well as continuing to reduce long- term agreements within the insurance operations in order to take advantage of improvements in market conditions when and where they occur.
In 2011, these initiatives will continue. In addition, in recent quarters the Company’s focus shifted to concentrate on strategic growth and investment in areas where the Company believes it can achieve appropriate returns. Recent strategic growth initiatives include the expansion of the U.S. construction and surety lines, new innovative products, including a product recall policy for the food and beverage industry and a creative multi-year product warranty technology program, and the further move into emerging markets. In December 2010 the Company announced that it had been granted a license to operate as a P&C company in Shanghai, China. This represents a significant step in the implementation of the Company’s strategy to strengthen its presence in emerging markets. There will also be significant investment in 2011 to install systems to both achieve greater efficiency and to create a platform from which the Company can grow as markets allow.
Despite some early positive signs in 2009, credit spreads narrowed sharply throughout 2009 and this continued into 2010. The credit markets brought capital back into the market, strengthening balance sheets and putting increased pressure on market pricing which continues today. However, in the U.S. there have been some recent indications of economic improvement which is reflected in some of the Company’s larger, more complex institutional clients’ exposure growth predictions. The market outlook for Europe is mixed, with Germany continuing to perform strongly and further improve while the U.K. and other markets
remain weak. As already mentioned, the Company is seeing growth opportunities in the emerging markets books through the granting of the Chinese license and further opportunities in Latin America.
The following is a summary of the January 2011 rate indications and recent renewal activity for each of the Insurance and Reinsurance segments of the Company:
With regard to market conditions, within the Insurance segment’s core lines of business, fourth quarter 2010 renewals reflected broadly flat premium rates in aggregate. While this reflects an improvement over the previous three quarters, the improvement is the result of some stronger pricing in excess casualty and a specific international professional program, offset by what continues to be a very competitive marketplace for most lines of business. This is particularly the case in both property and U.S. based professional lines where, rate decreases are in the low to mid single digits.
The Company continues to focus on those lines of business that it believes provide the best return on capital, including the writing of selective new business and remaining committed to the underwriting actions initially taken in 2009. Looking forward in 2011, initial indications are consistent with current market conditions described above. In the International P&C business unit, where nearly 40% of the book renews on January 1st, the Company experienced strong retentions across all product lines, including 86% based on accounts and 90% based on premium, and initial pricing indications are broadly stable.
As mentioned above, January 1, 2011 renewals saw rate deterioration across most lines of business and the market expectation is that these competitive trading conditions will continue for some time to come in most sectors. Despite this, the segment continues to develop new business opportunities in several areas, including the U.K. motor and marine markets, Bermuda catastrophe business and some select opportunities in the U.S. Looking ahead for the remainder of 2011, the segment will continue its philosophy of disciplined underwriting while seeking opportunities for strategic growth.
The Company seeks to generate income and book value growth 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 the year ended December 31, 2010, interest rates declined in the Company’s major markets and corporate credit spreads tightened. The Company’s results of operations and investment portfolio during the year ended December 31, 2010 were impacted by these trends. Net investment income yields were negatively impacted as a result of lower short-term interest rates, particularly U.S. LIBOR, on floating rate assets, higher allocations to lower yielding government, agency and cash securities, and reduced prevailing yields on reinvestment income. Net realized losses resulted from sales transactions in relation to the Company’s portfolio optimization efforts, and other-than-temporary impairment charges relating to the deterioration of future cash flow estimates, particularly in below investment grade non-agency RMBS. The impact of decreasing government rates during the twelve months ended December 31, 2010 was the primary reason for the improvement in the net unrealized position on fixed maturities and short-term investments combined with tightening credit spreads and net realized losses over the course of the year. For further information, see Item 7, “Investment Activities” below.
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, or IBNR. The Company’s lower underwriting results for 2010 as compared to 2009 were due to higher net losses incurred from natural catastrophes, which were $294.3 million in 2010 as compared to $52.3 million in 2009. In addition, other large loss events, as well as property losses relating to the Deepwater Horizon oil rig, contributed to the
Book value per share is a non-GAAP financial measure and is calculated by dividing ordinary shareholders’ equity by the number of outstanding ordinary shares at any period end. Book value per ordinary share is affected primarily by the Company’s net income (loss), by any changes in the net unrealized gains and losses on its investment portfolio, currency translation adjustments and also the impact of any share buyback or issuance activity.
The combined ratio for P&C operations is used by the Company and many other insurance and reinsurance companies as another measure of underwriting profitability. The combined ratio is calculated from the net losses incurred and underwriting expenses as a ratio of the net premiums earned for the Company’s insurance and reinsurance operations. A combined ratio of less than 100% indicates an
underwriting profit and greater than 100% reflects an underwriting loss. The Company’s combined ratio for the year ended December 31, 2010 is higher than for the same period in the previous year, primarily as a result of an increase in the loss and loss expense ratio, partially offset by a decrease in the underwriting expense ratio. The loss and loss expense ratio has increased as a result of higher levels of catastrophe losses and other large loss events in both the insurance and reinsurance segments. The decreased underwriting expense ratio reflects the Company’s restructuring activities over the last several years.
The Company’s combined ratio for the year ended December 31, 2009, is slightly lower than the same period in the previous year, primarily as a result of a decrease in the loss and loss expense ratio, partially offset by an increase in the underwriting expense ratio. The loss and loss expense ratio has declined as a result of lower levels of catastrophe losses in both the insurance and reinsurance segments and lower current year professional lines losses in the insurance segment partially offset by larger prior year reserve releases reported in 2008. The increased underwriting expense ratio has been driven largely by increases in operating expenses against lower net premiums earned. Operating expenses increased mainly as a result of the Company’s two restructuring activities already mentioned.
Net investment income related to P&C operations is an important measure that affects the Company’s overall profitability. The largest liability of the Company relates to its unpaid loss reserves, and the Company’s investment portfolio provides liquidity for claims settlements of these reserves as they become due. As a result, a significant part of the investment portfolio is invested in fixed income securities. Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates and credit spreads and changes in overall asset allocation. Net investment income related to P&C investment portfolio decreased by $102.5 million during 2010 as compared to the same period in the prior year. Overall, portfolio yields have decreased as a result of the impact of declines in U.S. interest rates, and particularly the impact of decreased U.S. LIBOR on the Company’s floating rate securities. Should investments yields remain low, overall profitability and cash flow will continue to be negatively impacted.
Net investment income related to property and casualty and corporate operations decreased by $398.6 million during 2009 as compared to same period in the prior year. Overall, portfolio yields have decreased as a result of the impact of declines in U.S. interest rates, and particularly the impact of decreased U.S. LIBOR on the Company’s floating rate securities previously supporting the GIC and funding agreement business. In addition, the Company increased its holdings in lower-yielding cash, government and agency RMBS securities in connection with its investment portfolio de-risking efforts as the Company re-aligns its portfolio to one more typical of a P&C investment portfolio and to increase liquidity.
Book value per ordinary share increased by $5.73 in the year to December 31, 2010 as compared to an increase of $9.18 during 2009. The increase in 2010 was a result of improved investment portfolio fair values, higher net income and the impact of share buyback activity. During 2010, there was a decrease in net unrealized losses on available for sale investments of $1.1 billion, net of tax, as compared to December 31, 2009. The improved investment portfolio fair values were due in large part to declining interest rates during 2010 but also tightening spreads.
Net income attributable to ordinary shareholders increased by $378.9 million during 2010 compared to the same period in the previous year. This increase was comprised of an increase in net income attributable to XL-Ireland of $568.4 million offset by a decrease of $195.2 million in the gains associated with the two
Fully diluted book value per ordinary share is a non-GAAP financial measure and represents book value per ordinary share combined with the impact from dilution of share based compensation including in-the-money stock options at any period end. Fully diluted book value per ordinary share increased by $5.18 and increased by $9.14 during the years ended December 31, 2010 and 2009, respectively, as a result of the factors noted above.
Return on average ordinary shareholder’s equity (“ROE”) is another non-GAAP financial measure that management considers important in evaluating the Company’s operating performance. ROE is calculated by dividing the net income for any period by the average of the opening and closing ordinary shareholders’ equity. The opening and closing ordinary shareholders’ equity amounts were determined by subtracting from opening and closing shareholders’ equity attributable to XL-Ireland, the non-controlling interest in equity of consolidated subsidiaries and the preference ordinary shareholders’ equity balances. The Company establishes minimum target ROEs for its total operations, segments and lines of business. If the Company’s minimum ROE targets over the longer term are not met with respect to any line of business, the Company seeks to modify and/or exit these lines. In addition, among other factors, the Company’s compensation of its senior officers is dependent on the achievement of the Company’s performance goals to enhance shareholder value as measured by ROE (adjusted for certain items considered to be “non-operating” in nature).
The Company’s net income and other financial measures as shown above for the year ended December 31, 2010 have been affected by the following significant items, among other things:
1. Impact of different levels of catastrophe and large loss events
Net losses incurred from natural catastrophes were higher in 2010 at $294.3 million as compared to $52.3 million in 2009. Notable natural catastrophes during 2010 included the Chilean Earthquake, European Windstorm Xynthia, U.S. tornadoes and hailstorm activity, the New Zealand Earthquake and floods in Central Europe, China, Poland and Queensland, Australia. In addition, other large loss events as well as property losses relating to the Deepwater Horizon oil rig contributed to the higher risk losses in 2010 than during 2009.
Overall, 2009 experienced a lower number of natural catastrophes as compared to 2008. In 2009, natural catastrophes included Hailstorm Wolfgang, Japanese earthquake, Windstorm Klaus, Typhoon Ketsana, Asian earthquake and tsunami and Australian wildfires.
During 2010, net favorable prior year development totaled $372.9 million in the Company’s property and casualty operations and included net favorable development in the Insurance and Reinsurance segments of $127.4 million and $245.5 million, respectively. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Item 8, Note 11 to the Consolidated Financial Statements, “Losses and Loss Expenses,” for further information regarding the developments in prior year loss reserve estimates for each of the years indicated within each of the Company’s operating segments.
Throughout 2010 and into 2011, the Company remains focused on, among other things, tailoring the Company’s business model to focus on core P&C business, optimizing the P&C investment portfolio, and enhancing its enterprise risk management capabilities. The Company continues to focus on those lines of business within its Insurance and Reinsurance segments that provide the best return on capital. The
Company’s derisking efforts within the P&C investment portfolio are substantially complete and, as a result of this progress, the Company is focused on optimizing the P&C investment portfolio. Details relating to the enterprise risk management and other initiatives are outlined below.
The Company’s risk appetite framework guides its strategies relating to, among other things, capital preservation, earnings volatility, net worth at risk, operational loss, liquidity standards, capital rating and capital structure, with the objective of preserving the Company’s capital base. This framework also addresses the Company’s tolerance to risks from material individual events (e.g., natural or man-made catastrophes such as terrorism), the Company’s investment portfolio, realistic disaster scenarios that cross multiple lines of business and risks related to some or all of the above that may actualize concurrently.
In relation to event risk management, the Company establishes net underwriting limits for individual large events as follows:
The Company imposes limits for each peril region/event type at a 1% exceedance probability. If the Company was to deploy the full limit, for any given peril region/event type, there would be a 1% probability that an event would occur during the next year which would result in a net underwriting loss in excess of the limit.
The Company also imposes limits for certain other event types at a 0.4% exceedance probability as described in further detail below. If the Company were to deploy the full limit, for any given event type, there would be a 0.4% probability that an event would occur during the next year which would result in a net underwriting loss in excess of the limit.
Per event 1% exceedance probability underwriting limits for “Tier 1 event types,” which include natural catastrophes, terrorism and other realistic disaster scenarios, are set at a level not to exceed approximately 15% of Tangible Shareholders’ Equity.
Per event 0.4% exceedance probability underwriting limits for “Tier 2 event types” are set at a level not to exceed 15% of Tangible Shareholders’ Equity. The 0.4% exceedance probability limit is used for Tier 2 event types rather than a TVaR measure due to the difficulty in estimating the full distribution of outcomes in the extreme tail of the distribution for these risk types as required for the TVaR measure.
Loss exposure estimates for all event risks are derived from a combination of commercially available and internally developed models together with the judgment of management, as overseen by the Board. Actual incurred losses may vary materially from the Company’s estimates. Factors that can cause a deviation between estimated and actualized loss potential include:
Natural catastrophe models incorporate and are critically dependent on meteorological, seismological and other earth science assumptions and related statistical relationships that may not be representative of prevailing conditions and risks, and may therefore misstate how particular events actually materialize, causing a material deviation between forecasted and actual damages associated with such events; and
uncertainty around the Company’s ability to measure exposures associated with individual events and combinations of events. This uncertainty could cause actual exposures and losses to deviate from those amounts estimated below, which in turn can create a material adverse effect on the Company’s financial condition and results of operations and may result in substantial liquidation of investments, possibly at a loss, and outflows of cash as losses are paid.
The table below shows the Company’s estimated per event net 1% and 0.4% exceedance probability exposures for certain peak natural catastrophe perils regions. These estimates assume that amounts due from reinsurance and retrocession purchases are 100% collectible. There may be credit or other disputes associated with these potential receivables.
As a continuing part of the Company’s focus on strategy, management has created an Office of Strategic Growth, headed by Greg Hendrick, Executive Vice President, Strategic Growth, that oversees the implementation of the strategic plan, coordinates the implementation work plans and creates planning milestones and metrics for success. Specifically, along with the Leadership Team, this office is focusing on, among other matters, the acquisition of talent and teams as well as areas in which XL can innovate and capitalize on its underwriting expertise.
different amounts would be reported under different conditions or using different assumptions. If actual events differ significantly from the underlying assumptions or estimates applied for any or all of the accounting policies (either individually or in the aggregate), there could be a material adverse effect on the Company’s results of operations, financial condition and liquidity. These critical accounting policies have been discussed by management with the Audit Committee of the Company’s Board of Directors.
1) Unpaid Loss and Loss Expenses and Unpaid Loss and Loss Expenses Recoverable
As the Company earns premiums for the underwriting risks it assumes, it also establishes an estimate of the expected ultimate losses related to the premium. Loss reserves for unpaid loss and loss expenses are established due to the significant periods of time that may elapse between the occurrence, reporting and settlement of a loss. The process of establishing reserves for unpaid property and casualty claims can be complex and is subject to considerable variability, as it requires the use of informed estimates and judgments. These estimates and judgments are based on numerous factors, and may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Loss reserves include:
As noted above, case reserves for the Company’s reinsurance operations are generally established based on reports received from ceding companies. Additional case reserves may be established by the Company to reflect the Company’s estimated ultimate cost of a loss. In addition to information received from ceding companies on reported claims, the Company also utilizes information on the pattern of ceding company loss reporting and loss settlements from previous catastrophic events in order to estimate the Company’s ultimate liability related to catastrophic events such as hurricanes. Commercial catastrophe model analyses and zonal aggregate exposures are utilized to assess potential client loss before and after an event. Initial cedant loss reports are generally obtained shortly after a catastrophic event, with subsequent updates received as new information becomes available. The Company actively requests loss updates from cedants periodically for the first year following an event. The Company’s claim settlement processes also incorporate an update to the total loss reserve at the time a claim payment is made to a ceding company.
Over time, as a greater number of claims are reported, actuarial estimates of IBNR are based on the BF and loss development techniques. The BF method utilizes actual loss data and the expected patterns of loss emergence, combined with an initial expectation of ultimate losses to determine an estimate of ultimate losses. This method may be appropriate when there is limited actual loss data and a relatively less stable pattern of loss emergence. The chain ladder method utilizes actual loss and expected patterns of loss emergence to determine an estimate of ultimate losses that is independent of the initial expectation of ultimate losses. This method may be appropriate when there is a relatively stable pattern of loss emergence and a relatively larger number of reported claims. Multiple estimates of ultimate losses using a variety of actuarial methods are calculated for each of the Company’s (150+) classes of business for each year of loss experience. The Company’s actuaries look at each class and determine the most appropriate point estimate based on the characteristics of the particular class and other relevant factors, such as historical ultimate loss ratios, the presence of individual large losses, and known occurrences that have not yet resulted in reported losses. Once the Company’s actuaries make their determination of the most appropriate point estimate for each class, this information is aggregated and presented to management for review and approval.
Due to the low frequency and high severity nature of some of the business underwritten by the Company, the Company’s reserve estimates are highly dependent on actuarial and management judgment and are therefore uncertain. In property classes, there can be additional uncertainty in loss estimation related to large catastrophe events. With wind events, such as hurricanes, the damage assessment process may take more than a year. The cost of claims is subject to volatility due to supply shortages for construction materials and labor. In the case of earthquakes, the damage assessment process may take several years as buildings are discovered to have structural weaknesses not initially detected. The uncertainty inherent in IBNR reserve estimates is particularly pronounced for casualty coverages, such as excess liability, professional liability coverages, and workers’ compensation, where information emerges relatively slowly over time.
High layer excess casualty insurance claims typically involve claims relating to (i) a “shock loss” such as an explosion or transportation accident causing severe damage to persons and/or property over a short period of time, (ii) a “non-shock” loss where a large number of claimants are exposed to injurious conditions over a longer period of time, such as exposure to chemicals or pharmaceuticals or (iii) a professional liability loss such as a medical malpractice claim. In each case, these claims are ultimately settled following extensive negotiations and legal proceedings. This process typically takes 5 to 15 years following the date of loss.
Discontinued asbestos and long-tail environmental business were contained within certain policies previously written by NAC Re Corp. (now known as XL Reinsurance America Inc.), prior to its acquisition by the Company. As at December 31, 2010, total gross unpaid losses and loss expenses in respect of this business represented less than 1% of unpaid losses and loss expenses.
The ratio of IBNR to total reserves has increased in recent years, with the increase attributable to casualty and professional lines of business. This is due to the current size of these businesses relative to the reserves of the mature years now running off. Additionally these reserves have a higher proportion of IBNR to total reserves in recent years due to the increased uncertainty around credit crisis claims and excess casualty claims. Typically, the ratio of IBNR to total reserves is greater for casualty (including professional) lines (which are longer-tail in nature) than for property lines due to the policy forms utilized and timing of loss reporting and settlement.
The following table shows the recorded estimate and the high and low ends of the range of the Company’s net unpaid losses and loss expenses for each of the lines of business noted above at December 31, 2010:
The Company’s methodology in 2010 for calculating reserve ranges around its single point reserve estimate is consistent with that used in 2009. The Company modeled a statistical distribution of potential reserve outcomes over a one year run-off period for each of the approximately 35 lines of business. In doing so the Company evaluated a number of alternative models, and for each line of business the Company’s actuaries selected the distribution parameters deemed to be most appropriate. Factors affecting this decision included an assessment of the model fit, availability and relevance of data and the impact of changes in business mix. The Company used the modeled statistical distribution to calculate an 80% confidence interval for the potential reserve outcomes over this one year run-off period. The high and low end points of the ranges set forth in the above table are such that there is a 10% modeled probability that the reserve will develop higher than the high point and a 10% modeled probability that the reserve will develop lower than the low point.
The recognition of unpaid losses and loss expenses recoverable requires two key judgments. The first judgment involves the Company’s estimation of the amount of gross IBNR to be ceded to reinsurers. Ceded
IBNR is generally developed as part of the Company’s loss reserving process and, consequently, its estimation is subject to similar risks and uncertainties as the estimation of gross IBNR (see “Critical Accounting Policies and Estimates - Unpaid losses and loss expenses and unpaid loss and loss expense recoverable”). The second judgment involves the Company’s estimate of the amount of the reinsurance recoverable balance that the Company will ultimately be unable to recover from related reinsurers due to insolvency, contractual dispute, or for other reasons. Amounts estimated to be uncollectible are reflected in a bad debt provision that reduces the reinsurance recoverable balance. Changes in the bad debt provision are reflected in net income. See Item 8, Note 12 to the Consolidated Financial Statements, “Reinsurance,” for further information.
The future policy benefit reserves for these annuity portfolio reinsurance contracts amounted to $4.3 billion and $4.6 billion at December 31, 2010 and 2009, 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 approximately a $34 million increase in the value of future claims related to annuity portfolio reinsurance.
The liabilities relate to in-force blocks of business, which are comprised of underlying insurance policies that provide mainly lump sum benefits if the policyholder dies. The liabilities are therefore driven by the rates of mortality, and a 1% increase in the mortality rate relative to the reserving assumption would increase the value of future claims by approximately $9 million. The liabilities are also affected by lapse experience, and a 1% decrease in lapse rates relative to the reserving assumption would increase the reserve by approximately $1.5 million. No changes to the locked-in assumptions were made in 2010, 2009 or in
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These primary factors include (i) an analysis of the liquidity, business prospects and financial condition of the issuer including consideration of credit ratings, (ii) the significance of the decline, (iii) an analysis of the collateral structure and other credit support, as applicable, of the securities in question, and (iv) for debt securities, whether the Company intends to sell such securities. In addition, the authoritative guidance requires that OTTI for certain asset backed and mortgage backed securities are recognized if the fair value of the security is less than its discounted cash flow value and there has been a decrease in the present value of the expected cash flows since the last reporting period. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to discounted cash flow and a portion of the previously unrealized loss is therefore realized in the period such determination is made.
If the Company intends to sell an impaired debt security, or it is more likely than not that it will be required to sell the security before recovery of its amortized cost basis, the impairment is other-than-temporary and is recognized in earnings in an amount equal to the entire difference between fair value and amortized cost.
The Company utilizes assumptions specific to its individual holdings and, accordingly, individual assumptions will differ on a security by security basis depending on the quality of the collateral and the performance of the underlying pools. In general, the Company projects that future defaults will develop based on the performance of the underlying collateral, measured by the number of loans currently in arrears.
2 base cases assuming asset defaults are equivalent to either the expected corporate default probabilities, or the cumulative default rates for similar time frames from the period of 1983 to 2008
Optimistic/pessimistic cases assuming assets have a default rate equivalent to 1 rating notch higher/ lower than their current rating and if on positive/negative watch then 2 notches higher/lower than their current rating
CMBS, which are dominated by AAA rated holdings which generally have high levels of credit subordination, are highly diversified and priced reasonably close to par. The Company reviews these holdings on an individual security basis to the extent they meet the screens noted above, but generally does not believe these securities to have a high risk of credit loss given their high subordination levels.
Other ABS, which is a mix of mostly investment grade credit card, auto and non-U.S. ABS structures that have risk and performance characteristics unrelated to the U.S. housing market. In cases where these sectors have met Company screens, the individual securities are evaluated based on fundamental credit analysis of the underlying structure.
The amount of proportional and excess of loss reinsurance gross premiums written and gross acquisition expenses recognized by the Company’s reinsurance operations for each line of business for the years ended December 31, 2010, 2009 and 2008 was as follows:
Gross and net premiums written increased by 3.9% and 5.7%, respectively, during the year ended December 31, 2010 as compared to the same period of 2009. Gross premiums written increased by 4.2 % when evaluated in the local currency. A large proportion of the gross and net premiums written increase related to a multi-year agreement with gross written premium of $126.5 million written in primary casualty during the fourth quarter of 2010. Excluding this multi-year program, across most lines of business, premium levels were flat, having been maintained despite continued challenging market conditions and strong competition, which continue to negatively impact new business and pricing. In addition, there have been improved retention rates across most lines of business as a result of the Company’s stronger financial condition and market position since the end of 2009. New business growth in upper middle market, marine and offshore energy, active programs, U.S. general aviation, and select professional businesses has been offset by decreases in North America environmental and excess and surplus lines, the run-off of a large U.S. automobile warranty program, the termination of a specialty lines aviation program in 2009 and decreases in U.S.-based professional lines due to continued market pressures and pricing. The increase in net premiums written was due to a reduction in ceded written premiums partially offset by the increase in gross premiums written noted above. The decrease in ceded written premiums is largely related to specialty lines due to cost savings from a restructuring of the marine and specie global, and property excess of loss reinsurance treaties, as well as certain adjustments to premium estimates in aviation and property which gave rise to a positive variance over 2009.
in insured values, fewer LTAs which are being renewed on a single year basis and unfavorable foreign exchange rate impacts. Offsetting the overall decrease was growth in professional lines and new business from the Company’s middle market strategy. The renewal pricing steadily improved throughout 2009 over most lines of business, with an overall modest increase of 1% across the entire book. Retention rates largely returned to historic levels. The decrease in net premiums written was due to the decrease in gross premiums written noted above partially offset by a reduction in ceded premiums as compared to the same period in 2008. The relative decrease in ceded premiums was driven by a shift from proportional to excess of loss treaties partially offset with increased rates in property and environmental lines.
Net premiums earned decreased by 0.9% in 2010 as compared to 2009 and by 10.9% in 2009 as compared to 2008. These decreases were primarily a reflection of the overall reduction of net premiums written over the last 12 to 24 months.
For further information on the net favorable prior year reserve development of $127.4 million and $62.9 million for the years ended December 31, 2010 and 2009 see Item 8, Note 11 to the Consolidated Financial Statements, “Losses and Loss Expenses.”
The increase in the underwriting expense ratio in the year ended December 31, 2009, compared to the same period in 2008, was due to an increase in the acquisition expense ratio of 0.5 points (12.1% as compared to 11.6%) combined with an increase in the operating expense ratio of 2.1 points (19.3% as compared to 17.2%). The increase in the acquisition expense ratio was primarily as a result of changes in the mix of business given the decreases in property and casualty lines which carry the lowest levels of acquisition cost. The increase in the operating expense ratio is attributable to the lower level of earned premium combined with the costs associated with the Company’s expense reduction initiatives announced in the third quarter of 2008 and first quarter of 2009 including changes to the Company’s previously communicated operational transformation program and the previously announced internal business realignment within the Insurance segment.
Fee income and other decreased in the year ended December 31, 2010 compared to the same period in 2009 mainly as a result of lower engineering fee income associated with the Company’s loss prevention consulting services business coupled with other expenses in professional lines related to the cost of an endorsement facility with National Indemnity Company, under which National Indemnity Company issued endorsements to certain “Side A” directors and officers liability insurance policies underwritten by XL Specialty Insurance Company. For further information, see Item 8, Note 10, to the Consolidated Financial Statements, “Other Investments.” During the first quarter of 2010, management concluded that it did not require the $100 million extension to this endorsement facility and did not purchase the related payment obligation.
Fee income and other decreased in 2009 as compared to 2008 mainly as a result of lower engineering fee income associated with the Company’s loss prevention consulting services business coupled with other expenses in professional lines due to the cost of the National Indemnity facility.
Gross premiums written decreased by 0.9% while net premiums written increased by 4.6% during the year ended December 31, 2010 compared with the same period of 2009. Gross premiums written decreased by 2.2% when evaluated in the local currency. The gross premium written decrease was mainly from the North America property business where there have been lower premiums on a U.S. agricultural program due to a fall in commodity prices. In addition, the exit of certain casualty facultative markets, non renewed business, cancellations and certain reductions in price and capacity also contributed to the marginal reduction in gross premiums written. Offsetting the reduction was premium growth from the recapture of business lost during 2009 following ratings actions as well as new business in Europe, Bermuda and Asia and loss related premium adjustments in Europe. The increase in net premiums written was mainly due to the reduction in ceded written premiums as a result of a reduction in volume associated with the U.S. agricultural program already mentioned above, of which a significant portion was retroceded.
Net premiums earned decreased by 5.7% in 2010 as compared to 2009 and by 20.1% in 2009 as compared to 2008. These decreases were primarily a reflection of the overall reduction of net premiums written over the last three years.
The decrease in the underwriting expense ratio for the year ended December 31, 2010 compared to the same period in 2009 was due to a decrease in the acquisition expense ratio of 0.4 points (21.4% as compared to 21.8% in 2009), and by a decrease in the operating expense ratio of 0.3 points (11.7% as compared to 12.0% in 2009). The decrease in the acquisition expense ratio was a result of reduced net earned premiums in relation to the credit and bond book of business in Europe following a decision to exit these lines in 2010, which carries very high acquisition costs combined with reinstatement premium adjustments. The decrease in the operating expense ratio was as a result of costs savings associated with the Company’s expense reduction initiatives announced in the third quarter of 2008 and first quarter of 2009, including changes to the Company’s previously communicated operational transformation program.
Net results from structured reinsurance products include certain structured indemnity contracts that are accounted for as deposit contracts. Net results from these products for the year ended December 31, 2010 decreased compared to the same period in 2009. This decrease was mainly due to higher interest expense associated with an accretion rate adjustment based on changes in expected cash flows on some of the larger deposit accounted transactions combined with lower net investment income as a result of lower yields and a smaller investment base which is reflective of the run off nature of this line of business.
Fee income and other decreased by $3.7 million in 2010 as compared 2009, which included the sale of underwriting year 2009 renewal rights for the European life, accident and health business.
Prior to the decision being made to run-off the business, products offered included a broad range of underlying lines of life reinsurance business, including term assurances, group life, critical illness cover, immediate annuities and disability income. In addition, prior to selling the renewal rights, the products offered included short-term life, accident and health business. The segment also covers a range of geographic markets, with an emphasis on the U.K., U.S., Ireland and Continental Europe.
Gross premiums written relating to other life business decreased by $157.1 million in year ended December 31, 2010 as compared to the same period in 2009. For the core underlying book of term assurance and critical illness cover, a decrease of $110.0 million in gross premiums written is due to novations and recaptures, and $12.1 million due to unfavorable foreign exchange rate movements; offset by premium growth in UK/Irish business of $7.1 million. Further, there were $35.8 million lower gross written premiums as a result of the sale of the U.S. business in 2009 and gross premiums written related to short-term life, accident and health business decreased by $5.7 million in line with run-off expectations.
Gross premiums written relating to other life business decreased by $84.6 million in the year ended December 31, 2009 as compared to the same period in 2008. For the core underlying book of term assurance and critical illness cover, unfavorable foreign exchange rate movements of $37.1 million were partially offset by premium growth in U.K./Irish business of $38.7 million and premium growth in U.S. business of $3.2 million. In addition, gross premiums written related to short-term life, accident and health business decreased by $79.7 million primarily as the renewal rights for this business were sold in late 2008.
Gross premiums written relating to annuity business decreased by $30.2 million during the year ended December 31, 2009 as compared to the same period in 2008 mainly due to unfavorable foreign exchange rate movements of $26.5 million and $3.7 million lower premiums from annuity business which decrease through time as defined by the treaties. Ceded premiums written were roughly consistent with the prior year.
Net premiums earned in the year ended December 31, 2010 decreased 31.0% as compared to the same period in 2009 and in the year ended December 31, 2009 decreased by 14.6% as compared to the same period in 2008. The decreases in 2009 and 2008 were consistent with the movements in total gross and net premiums written as described above.
For the year ended December 31, 2010, acquisition costs decreased by 36.8% as compared to the same period in 2009, largely as a result of the absence of novated/recaptured treaties from the core long-term portfolio and the absence of the U.S. business this year; as well as decreases in line with run-off expectations. Operating expenses decreased by 34.6% in the twelve months ended December 31, 2010 as compared to the same period in the prior year mainly due to lower compensation expenses resulting from lower headcount and lower costs related to acquisition of new business.
Acquisition costs in 2009 decreased by 19.3% as compared to the same period in 2008, largely as a result of the lower renewal premiums associated with the short-term life, accident and health business and favorable foreign exchange rate impacts. Operating expenses decreased by 51.7% in the twelve months ended December 31, 2009 as compared to the same period in the prior year mainly due to lower compensation expenses resulting from lower headcount and lower costs relating to acquisition of new business.
For further information on Syncora, see “Results of Operations” and “Other Revenues and Expenses” within Management’s Discussion and Analysis of Financial Condition and Results of Operations. In addition, see Item 8, Notes 4 and 9 to the Consolidated Financial Statements, “Syncora Holdings Ltd (“Syncora”)” and “Investments in Affiliates,” for further information.
Net income from investment fund affiliates includes earnings from the Company’s investments in closed-end investment funds and partnerships and similar vehicles that are accounted for under the equity method.
Net income from investment fund affiliates decreased in the year ended December 31, 2010 compared to the same period of 2009. These results reflect solid results from the Company’s private investment portfolio for 2010, as compared to a loss during 2009, offset by earnings from alternative funds, which were lower than the results during 2009. Performance in alternative funds in 2009 was particularly strong.
Net income from investment fund affiliates in the year ended December 31, 2009 resulted from the significant improvement in market sentiment and rallies in risk assets. Credit sensitive and relative value managers particularly benefited from tightening credit spreads and normalization of previously dislocated relative value relationships. Volatility remained high relative to historical levels, allowing alternative managers to be more opportunistic and take advantage of pricing dislocations, but offset by the negative mark-to-market in the Company’s private investment portfolio reflecting fair value adjustments, particularly during the fourth quarter of 2008.
Performance on the alternative portfolio reflects the twelve months ended November 30, 2010 and 2009, respectively.
For the year ended December 31, 2010, net realized losses of $270.8 million included net realized losses of $65.7 million from sales of investments and $205.1 million related to other-than-temporary impairments of certain of the Company’s fixed income, equity and other investments.
For the non-equity accounted alternative and private investment security portfolios, the Company recorded impairments of $7.4 million for the year ended December 31, 2010 because the holdings were impaired by more than 50% of amortized cost.
Net realized and unrealized losses on investment derivatives for the years ended December 31, 2010, 2009 and 2008 resulted from the Company’s investment strategy to manage interest rate risk, foreign exchange risk and credit risk, and to replicate permitted investments. Derivative losses in 2010 and 2009 relate primarily to the impact of tightening credit spreads on certain credit derivatives purchased within the investment portfolio. In 2008, derivative losses were driven by foreign currency exchange losses recognized on a sterling forward currency contract hedging U.S. dollar assets supporting U.K. sterling liabilities in the life operations during the year.
Financial operating affiliate income increased during the year ended December 31, 2010 as compared to the same period of 2009 due to the sale of a significant portion of the Company’s shareholding in Primus Guaranty Ltd. For further information on the sale of Primus shares, see Note 9 to the Consolidated Financial Statements, “Investments in Affiliates.”
Investment manager affiliate income increased during the year ended December 31, 2010 as compared to the same period of 2009 primarily as a result of positive capital market conditions since the fourth quarter of 2009 compared to the challenging conditions for alternative asset managers reported in the fourth quarter of 2008 and first two quarters of 2009. Managers have generally benefited in the past year from higher asset levels and, where they charge incentive fees, from a return above their high-water-marks, where new incentive fees are earned. Finally, the Company also benefited from a $4.4 million gain associated with the sale of its stake in one of the investment manager affiliates in the first quarter of 2010.
Income from other strategic operating affiliates decreased during the year ended December 31, 2010 as compared to the same period of 2009 mainly due to lower earnings in 2010 relating to an insurance affiliate which largely writes direct U.S. homeowners insurance and lower earnings due to the sale of the Company’s Brazilian joint venture ITAU XL Seguros Corporativos S.A. during the second quarter of 2010.
Foreign exchange gains in the year ended December 31, 2010 were marginal as a result of a limited overall movement in the value of the U.S. dollar during the period. The U.S. dollar was stronger against the Euro, while weakening against the Swiss franc, Canadian dollar and Brazilian real. In the year ended December 31, 2009, the U.S. dollar weakened against all of the Company’s major currency exposures, particularly the Canadian dollar and U.K. sterling, generating a loss for that period.
Interest expense for the year ended December 31, 2009 as compared to the same period in 2008 was lower mainly as a result of lower interest associated with the retirement of the 2011 Senior Notes in February 2009 partially offset by interest associated with 8.25% senior notes which are part of the 10.75% Equity Security Units issued in August 2008. For more information on the Company’s financial structure, see “Liquidity and Capital Resources.”
Due to the financial market and economic events that occurred in the fourth quarter of fiscal 2008, the Company performed an interim impairment test for goodwill subsequent to its annual testing date of June 30. The interim impairment test resulted in a non-cash goodwill impairment charge of approximately $990.0 million. For further information, see Item 8, Note 7 to the Consolidated Financial Statements, “Goodwill and Other Intangible Assets,” and see further discussion under “Critical Accounting Policies and Estimates.”
The increase in the Company’s income taxes in 2010 as compared to 2009 arose principally from the increase in the profitability of the Company’s U.S. and European operations in 2010. The decrease in the Company’s income taxes in 2009 as compared to 2008 arose principally from the decrease in the profitability of the Company’s U.S. and European operations. See “Critical Accounting Policies and Estimates” and Item 8, Note 24 to the Consolidated Financial Statements, “Taxation.”
At December 31, 2010 and 2009, total investments, cash and cash equivalents, accrued investment income and net receivable for investments sold were $35.8 billion and $35.9 billion, respectively. The following table summarizes the composition of the Company’s invested assets at December 31, 2010 and 2009:
The following is an analysis of how long each of those investment securities with a gross unrealized loss at December 31, 2010 and 2009 had been in a continual unrealized loss position:
Hybrids are allocated on the call date and medium term notes are allocated on contractual maturity.
The following table details the Company’s corporate credit exposures by certain asset classes as well as ratings levels within the Company’s aggregate fixed income portfolio and the current net unrealized (loss) position as at December 31, 2010 and 2009:
At December 31, 2010, approximately $1.6 billion of the Company’s $4.4 billion in corporate financial sector securities was held in the portfolios supporting the Company’s life reinsurance business. Management completed a strategic review of the Company’s life reinsurance business, which is now in run-off. The assets associated with that business are more heavily weighted towards longer term securities from financial institutions, including Tier One and Upper Tier Two securities, with a fair value of $0.6 billion representing committed term debt and hybrid instruments senior to the common and preferred equity of the financial institutions, and accounted for $112.8 million of the Company’s net unrealized loss as at December 31, 2010. As at December 31, 2010, subordinated debt securities (including Lower Tier Two) had a fair value of $0.5 million and a net unrealized loss of $30.4 million. At December 31, 2010 approximately 40% of the overall sensitivity to interest rate risk (based on an immediate hypothetical +100 basis point adverse parallel shift in global bond curves) and approximately 32% to credit risk (based on an immediate hypothetical +100 basis point increase in all global corporate and structured credit spreads) was related to the Life operations portfolio. However, excluding the Life operations portfolio’s held to maturity fixed maturities, the sensitivity to interest rate risk decreases to approximately 22% of the overall sensitivity and decreases to approximately 19% of the overall sensitivity to credit spread risk. This portfolio only accounts for 19.1% of the aggregate fixed income portfolio.
At December 31, 2010, the Company’s Non-Agency RMBS exposures had adequate underlying loan characteristics and the Company believed at such date that the current amortized cost levels were at or below the discounted cash flow value of the holdings, based on an analysis of subordination levels relative to current expectations of house price declines, loss severities and default levels. During the year, net unrealized losses have decreased by $146.6 million due to the improvement in market value of these asset holdings in addition to sales. The Company had Non-Agency RMBS, with a fair value of approximately $681.0 million downgraded during the year ended December 31, 2010. However, 54.6% of the Company’s holdings remain rated investment grade at December 31, 2010.
For a discussion on the significant drivers of the gross unrealized losses at December 31, 2010, see Item 8, Note 8 to the Consolidated Financial Statements “Investments,” for further information.
The following table summarizes the fair value, gross unrealized losses, credit rating and asset class of securities in a gross unrealized loss position within the Company’s structured credit and corporate portfolios, which comprised 87.7% of the Company’s total gross unrealized loss position of $1.0 billion at December 31, 2010. The remaining gross unrealized loss is related to government and government-related/supported securities and is driven by foreign exchange and spread widening on agencies.
Included in the gross unrealized losses on corporate financials are gross unrealized losses of $143.9 million on Tier One and Upper Tier Two securities of financial institutions (“Hybrids”), as well as $50.5 million of unrealized losses on subordinated debt with a fair value of $1.0 billion.
Included in the gross unrealized losses on corporate financials are gross unrealized losses of $225.2 million on Tier One and Upper Tier Two securities of financial institutions (“Hybrids”), as well as $84.3 million on subordinated debt with a fair value of $1.1 billion.
At December 31, 2009, certain assets that were previously classified as Level 3 assets due to a lack of observable market data were classified as Level 2 assets due to sufficient market data becoming available to determine a price and to allow the use of broker quotes. As a result of numerous recent market factors, including increased volumes of trading, the Company believed that transactions in this market were no longer distressed and, accordingly, reverted to third-party vendor pricing sources where transactions available as of December 31, 2009, and, where not available, broker quotes. Accordingly, as at December 31, 2009, for those CDOs which were previously valued using internal models, the Company recognized these assets at a fair value of $538.5 million and a par value of $789.1 million. Of these holdings, $457.6 million were valued by third party vendors and, accordingly, were now classified as Level 2, and $ 80.9 million were valued using broker quotations and, accordingly, remained classified as Level 3.
The Company performs quarterly reviews of the prices received from its third party valuation sources to assess if the prices represent a reasonable estimate of the fair value. This process is completed by investment and accounting personnel who are independent of those responsible for obtaining the valuations. The approaches taken to gain comfort include, but are not limited to, comparing valuations between external sources and completing recurring reviews of third party pricing services’ methodologies. As a result
At December 31, 2010, the fair value of Level 3 assets and liabilities as a percentage of the Company’s total assets and liabilities that are carried at fair value was as follows:
The Other investments balance excludes certain structured transactions including certain investments in project finance transactions and a payment obligation (as described in Note 10, “Other Investments”), that has provided liquidity financing to a structured credit vehicle as a part of a third party medium term note facility. These Other investments are carried at amortized cost that totaled $327.7 million at December 31, 2010 and $365.6 million at December 31, 2009.
At December 31, 2010, Level 3 assets represented approximately 3.2% of the Company’s assets that are measured at fair value and less than 3% of total assets. Level 3 liabilities represented approximately 55.4% of the Company’s liabilities that are measured at fair value and less than 1% of total liabilities at December 31, 2010. As defined in the hierarchy, those assets and liabilities categorized as Level 3 have valuations determined using unobservable inputs. Unobservable inputs may include the entity’s own assumptions about market participant assumptions, applied to a modeled valuation; however, this is not the case with respect to the Company’s Level 3 assets and liabilities. The vast majority of the assets and liabilities classified as Level 3 are made up of those securities for which the values were obtained from brokers where either significant inputs were utilized in determining the value that were difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker were not able to be obtained to support a Level 2 classification.
See Note 3 to the Consolidated Financial Statements, “Fair Value Measurements,” for an analysis of the change in fair value of Level 3 Assets and Liabilities.
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. While reinsurance agreements are designed to limit the Company’s losses from large exposures and permit recovery of a portion of direct unpaid losses, reinsurance does not relieve the Company of its ultimate liability to the Company’s insureds. Accordingly, the losses and loss expense reserves on the balance sheet represent the Company’s total unpaid gross losses. Unpaid losses and loss expense recoverable relates to estimated reinsurance recoveries on the unpaid loss and loss expense reserves.
Reinsurance recoverable on unpaid losses and loss expenses were $3.7 billion at December 31, 2010, and 2009, respectively. At December 31, 2010 and 2009, reinsurance balances receivable were $0.2 billion
and $0.5 billion, respectively. The table below presents the Company’s net reinsurance recoverable and reinsurance balances receivable at December 31, 2010 and 2009:
The Company has credit risk should any of its reinsurers be unable or unwilling to settle amounts due. Of the $3.8 billion total unpaid losses and loss expenses recoverable and reinsurance balances receivable at December 31, 2010, one individual reinsurer accounted for 15% or more of the total. The Company is the beneficiary of letters of credit, trust accounts and funds withheld in the aggregate amount of $1.5 billion at December 31, 2010, collateralizing reinsurance recoverables with respect to certain reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify the Company primarily because of disputes under reinsurance contracts and insolvencies. As at December 31, 2010 and 2009, the Company had a reserve for potential non-recoveries from reinsurers of $121.9 million and $189.8 million, respectively.
Liquidity is a measure of the Company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of the Company’s business operations. As a global insurance and reinsurance company, one of the Company’s principal responsibilities to its clients is to ensure that the Company has ready access to funds with which to settle large unforeseen claims. The Company would generally expect that positive cash flow from operations (underwriting activities and investment income) will be sufficient to cover cash outflows under most future loss scenarios. However, there is a possibility that unforeseen demands could be placed on the Company due to extraordinary events and as such the
Company’s liquidity needs may change. Such events include, among other things, several significant catastrophes occurring in a relatively short period of time resulting in material incurred losses; rating agency downgrades of the Company’s core insurance and reinsurance subsidiaries that would require posting of collateral in connection with the Company’s letter of credit and revolving credit facilities, return of unearned premium and/or the settlement of derivative transactions and large scale uncollectible reinsurance recoverables on paid losses (as a result of coverage disputes, reinsurers’ credit problems or decreases in the value of collateral supporting reinsurance recoverables), etc. Any one or a combination of such events may cause a liquidity strain for the Company. In addition, a liquidity strain could also occur in an illiquid market, such as that which was experienced in 2008. Investments that may be used to meet liquidity needs in the event of a liquidity strain may not be liquid, given inactive markets, or may have to be sold at a significant loss as a result of depressed prices. Because each subsidiary focuses on a more limited number of specific product lines than is collectively available from the consolidated group of companies, the mix of business tends to be less diverse at the subsidiary level. As a result, the probability of a liquidity strain, as described above, may be greater for individual subsidiaries than when liquidity is assessed on a consolidated basis. If such a liquidity strain were to occur in a subsidiary, XL-Ireland may be required to contribute capital to the particular subsidiary and/or curtail dividends from the subsidiary to support holding company operations which may be difficult given that XL-Ireland is a holding company and has limited liquidity.
The Company’s principal uses of liquidity are for dividend payments to holders of its ordinary shares and preferred shares, interest and principal payments on debt, capital investments in its subsidiaries and corporate operating expenses.
Certain of the Company’s invested assets are held in trust and pledged in support of insurance and reinsurance liabilities. Such pledges are largely required by the Company’s operating subsidiaries that are “non-admitted” under U.S. state insurance regulations, in order for the U.S. cedant to receive statutory credit for reinsurance. In addition certain deposit liabilities and annuity contracts require the use of pledged assets. At December 31, 2010 and 2009, the Company had $16.1 billion and $16.7 billion in pledged assets, respectively.
During the fourth quarter of 2010, the Company purchased and cancelled 6.9 million ordinary shares for $144.0 million under the 2010 buyback program. Between January 1 and February 22, 2011, the Company purchased and cancelled an additional 5.3 million shares for $121.3 million under the 2010 buyback program. As of February 22, 2011, $734.7 million remains available for purchase under this buyback program.
Net cash used in financing activities was $1.5 billion in 2010 compared to net cash used of $1.0 billion in 2009. The 2010 net cash outflows related primarily to the redemption of Series C Preference Ordinary Shares, purchase of the Company’s ordinary shares as outlined above, settlement of $450 million of outstanding funding agreement liabilities, repayment of other deposit liabilities and the payment of ordinary and preferred dividends. For more information on the repurchase of debt, see Item 1, Note 20 to the Consolidated Financial Statements, “Share Capital.”
Following the settlement of the purchase contracts associated with the 7.0% ESUs in February 2009, the Company issued 11,461,080 ordinary shares for net proceeds of approximately $743.1 million, which was used to retire the senior notes previously due February 2011, which had a fixed coupon of 5.25%.
In the year ended December 31, 2008, net cash flows used in financing activities was $2.8 billion. The main drivers for the cash outflow in 2008 are summarized below.
In order to fund the payment of approximately $1.8 billion to Syncora under the Master Agreement in 2008 and the payment of approximately $283 million to consummate the redemption of X.L. America, Inc.’s 6.58% Guaranteed Senior Notes due 2011, the Company raised approximately $2.8 billion in August 2008 through an issuance of both ordinary shares and ESUs. Concurrent with the execution of the Master Agreement, the Company exercised the put option under its Mangrove Bay contingent capital facility entered into in July 2003, resulting in net proceeds to the Company of approximately $500 million in exchange for the issuance by XL-Cayman of 20,000,000 Series C Preference Ordinary Shares, par value U.S. $0.01 per share (the “Series C Preference Shares”). For further details on these transactions, see “Capital Resources,” below.
In July 2008, in conjunction with the issuance of ordinary shares and ESUs described above, the Board of Directors approved a reduction in the quarterly dividend payable on the Company’s ordinary shares to $0.19 per ordinary share beginning with the quarterly dividend paid in September 2008. In addition, in February 2009, the Board of Directors approved a further reduction in the quarterly dividend payable on the Company’s ordinary shares to $0.10 per ordinary share beginning with the quarterly dividend payable in March 2009.
The Company is a Well Known Seasoned Issuer (“WKSI”) as defined by the rules and regulations of the SEC. The Company maintains a shelf registration statement on Form S-3 and is eligible to file automatically effective registration statements in the future for the potential offering and sale of an unlimited amount of debt and equity securities. The registration statement allows for various types of securities to be offered, including the following (i) debt securities, preferred stock, common stock, depositary shares, warrants, stock purchase contracts, stock purchase units and junior subordinated deferrable interest debentures of the Company, (ii) preferred securities of any of one or more capital trusts organized by the Company and guarantees of such securities by the Company and (iii) debt securities of XL Capital Finance (Europe) plc and guarantees of such securities by the Company.
The following table summarizes the components of the Company’s current capital resources at December 31, 2010 and 2009:
“In Use” and “Outstanding” data represent December 31, 2010 accreted values. “Payments Due by Period” data represent ultimate redemption values.
In addition, see Note 15 to the Consolidated Financial Statements, “Notes Payable and Debt Financing Arrangements,” for further information.
senior Unsecured Notes of approximately $2.5 billion. These notes require the Company to pay a fixed rate of interest during their terms. At December 31, 2010, there were five outstanding issues of senior unsecured notes:
amount each - one tranche at 99.432% and the other at 98.419%. Aggregate gross proceeds were $593.6 million. Related expenses of the offering amounted to $4 million.
$575 million of senior notes due August 2021, with a fixed coupon of 8.25%. These securities are a component of the 10.75% Units that are publicly traded. In addition to the coupon paid on the senior notes, quarterly contract adjustment payments at an annual rate of 2.50% per annum are paid on forward purchase contracts for the Company’s common shares for a total distribution of 10.75% per annum. The purchase contracts mature in 2011, and the senior notes mature in 2021. In August 2011, the senior notes will be remarketed whereby the interest rate will be reset in order to generate sufficient remarketing proceeds to satisfy the 10.75% Unit holders’ obligations under the purchase contract.
As at December 31, 2010, the Company’s preferred share capital is made up of $1.0 billion Series E Preference ordinary shares and $ 71.9 million Series C Preference ordinary shares. As at December 31, 2009, the company’s preferred share capital is made up of $1.0 billion Series E Preference ordinary shares and $182.7 million Series C Preference ordinary shares.
On March 26, 2009, the Company completed a cash tender offer for its outstanding Series C Preference Ordinary Shares that resulted in approximately 12.7 million Series C Preference Ordinary Shares with a liquidation value of $317.3 million being purchased by the Company for approximately $104.7 million plus accrued and unpaid dividends, combined with professional fees totaling $0.8 million. As a result, a book value gain of approximately $211.8 million was recorded in the first quarter of 2009 to ordinary shareholders. In addition, see Note 20 to the Consolidated Financial Statements, “Share Capital,” for further information.
At December 31, 2010, the Company had one contingent capital transaction where the outstanding put option has not been exercised. No up-front proceeds were received by the Company under this transaction. In the event that the associated irrevocable put option agreement is exercised, proceeds previously raised from investors from the issuance of pass-through trust securities would be received in return for the issuance of preferred shares. See below for further details on this transaction.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of the Company’s foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”), with Stoneheath Re (“Stoneheath”). The net effect of these agreements to the Company is the creation of a contingent put option to issue $350.0 million of preference ordinary shares in the aggregate. The agreements provide the Company with a Reinsurance Collateral Account in support of certain covered perils named in the Reinsurance Agreement. The covered perils include United States wind, European wind, California earthquake and terrorism worldwide. After an initial three-month period, the covered perils as well as the attachment points and aggregate retention amounts may be changed by the Ceding Insurers in their sole discretion. This may result in a material increase or decrease in the likelihood of payment under the Reinsurance Agreement. On each date on which a Ceding
Insurer withdraws funds from the Reinsurance Collateral Account, the Company shall issue and deliver to Stoneheath an amount of XL-Cayman Series D Preference Shares (the “XL Preferred Securities”) having an aggregate liquidation preference that is equal to the amount of funds so withdrawn from the Collateral Account. The Company is obligated to reimburse Stoneheath for certain fees and ordinary expenses. The initial term of the Reinsurance Agreement was for the period from the Closing Date through June 30, 2007, with four annual mandatory extensions through June 30, 2011 (unless coverage is exhausted thereunder prior to such date). The Ceding Insurers may thereafter extend the Reinsurance Agreement at their option for additional calendar quarters without limit (unless coverage is exhausted thereunder). The fair value of the contingent put option recorded in earnings was nil at each of December 31, 2010 and 2009. The XL Preferred Securities, if issued, will pay dividends on a non-cumulative basis at a fixed rate of 6.868% per annum through October 15, 2011 and thereafter at a floating rate based on 3-month LIBOR, plus 3.12%.
At December 31, 2010, the Company had five letter of credit facilities in place with total availability of $5.0 billion, of which $2.4 billion was utilized.
Secured indebtedness excludes secured letter of credit facilities as permitted under the schedules to the credit facilities. At December 31, 2010, such secured letter of credit facilities amounted to $506.3 million.
Covenants require that none of XL Group, XL Insurance (Bermuda) Ltd or XL Re Ltd has a financial strength ratings of less than “A-” from A.M. Best. At December 31, 2010, the Company was in compliance with such covenants.
Under the Company’s five-year U.S. credit facility, in the event that XL Group, XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur.
The 6.5% Guaranteed Senior Notes indenture contains a cross default provision. In general, in the event that the Company defaults in the payment of indebtedness in the amount of $50.0 million or more, an event of default would be triggered under the 6.5% Guaranteed Senior Notes indentures. Given that all of the Company’s Debt Documents contain cross default provisions, this may result in all holders declaring such debt due and payable and an acceleration of all debt due under those documents. If this were to occur, the Company may not have funds sufficient at that time to repay any or all of such indebtedness.
The following table presents the Company’s long term contractual obligations and related payments as at December 31, 2010, due by period. This table excludes further commitments of $137.5 million to the Company’s related investment funds and certain limited partnerships, and letter of credit facilities of $2.4 billion. See Item 8, Note 16 to the Consolidated Financial Statements, “Derivative Instruments,” and Note 19 to the Consolidated Financial Statements, “Commitments and Contingencies.” See Item 8, Note 15 to the Consolidated Financial Statements, “Notes Payable and Debt and Financing Arrangements,” for further information.
The unpaid loss and loss expenses were $20,531,607 on the Company’s Consolidated Balance Sheet at December 31, 2010. The difference from the amount included above relates to the discount on payments due in the future for certain workers compensation lines. The timing and amounts of actual claims payments related to these P&C reserves vary based on many factors including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claims payments could differ materially from the Company’s estimated amounts. For information regarding the estimates for unpaid loss and loss expenses as well as factors effecting potential payment patterns of reserves for actual and potential claims related the Company’s different lines of business see “Critical Accounting Policies and Estimates” above. Certain lines of business written by the Company, such as excess casualty, have loss experience characterized as low frequency and high severity. This may result in significant variability in loss payment patterns and, therefore, may impact the related asset/liability investment management process. In order to be in a position, if necessary, to make these payments, the Company’s liquidity requirements are supported by having revolving lines of credit facilities available to the Company and significant reinsurance programs, in addition to the Company’s general high grade fixed income investment portfolio.
On December 5, 2006, the Company and certain operating subsidiaries (“Ceding Insurers”) entered into a securities issuance agreement (the “Securities Issuance Agreement”), and certain of the Company’s foreign insurance and reinsurance subsidiaries (“Ceding Insurers”) entered into an excess of loss reinsurance agreement (the “Reinsurance Agreement”), with Stoneheath Re (“Stoneheath”). The net effect of these agreements to the Company is the creation of a contingent put option in the amount of $350.0 million in the aggregate. The Company’s interests in Stoneheath represents an interest in a variable interest entity under current authoritative accounting guidance, however, the Company is not the primary beneficiary as contemplated in that guidance. Given that there are no contractual requirements or intentions to enter into additional variable interests in this entity; management considers the likelihood of consolidating Stoneheath in the future to be remote.
other written or oral statements made by or on behalf of the Company may include forward-looking statements that reflect the Company’s current views with respect to future events and financial performance. Such statements include forward-looking statements both with respect to the Company in general, and to the insurance and reinsurance sectors in particular (both as to underwriting and investment matters). Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “anticipate,” “will,” “may” and similar statements of a future or forward-looking nature identify forward-looking statements for purposes of the PSLRA or otherwise.
Consolidated Statements of Income for the years ended December 31, 2010, 2009 and 2008
Consolidated Statements of Comprehensive Income for the years ended December 31, 2010, 2009 and 2008
bid indications where pricing services do not provide coverage for a particular security. To the extent the Company believes current trading conditions represent distressed transactions, the Company may elect to utilize internally generated models. The pricing services use market approaches to valuations using primarily Level 2 inputs in the vast majority of valuations, or some form of discounted cash flow analysis, to obtain investment values for a small percentage of fixed income securities for which they provide a price. Pricing services indicate that they will only produce an estimate of fair value if there is objectively verifiable information available to produce a valuation. Standard inputs to the valuations provided by the pricing services listed in approximate order of priority for use when available include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers, and reference data. The pricing services may prioritize inputs differently on any given day for any security, and not all inputs listed are available for use in the evaluation process on any given day for each security evaluation; however, the pricing services also monitor market indicators, industry and economic events. Information of this nature is a trigger to acquire further corroborating market data. When these inputs are not available, they identify “buckets” of similar securities (allocated by asset class types, sectors, sub-sectors, contractual cash flows/structure, and credit rating characteristics) and apply some form of matrix or other modeled pricing to determine an appropriate security value which represents their best estimate as to what a buyer in the marketplace would pay for a security in a current sale. While the Company receives values for the majority of the investment securities it holds from pricing services, it is ultimately management’s responsibility to determine whether the values received and recorded in the financial statements are representative of appropriate fair value measurements. It is common industry practice to utilize pricing services as a source for determining the fair values of investments where the pricing services are able to obtain sufficient market corroborating information to allow them to produce a valuation at a reporting date. In addition, in the majority of cases, although a value may be obtained from a particular pricing service for a security or class of similar securities, these values are corroborated against values provided by other pricing services.
Broker quotations are used to value fixed maturities where prices are unavailable from pricing services due to factors specific to the security such as limited liquidity, lack of current transactions, or trades only taking place in privately negotiated transactions. These are considered Level 3 valuations, as significant inputs utilized by brokers may be difficult to corroborate with observable market data, or sufficient information regarding the specific inputs utilized by the broker was not available to support a Level 2 classification.
and if so, at inception, written premiums are fully earned and corresponding losses and loss expense recognized. The contracts can cause significant variances in gross premiums written, net premiums written, net premiums earned, and net incurred losses in the years in which they are written. Reinsurance contracts sold not meeting the established criteria for reinsurance accounting are recorded using the deposit method.
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These primary factors include (i) an analysis of the liquidity, business prospects and financial condition of the issuer including consideration of credit ratings, (ii) the significance of the decline, (iii) an analysis of the collateral structure and other credit support, as applicable, of the securities in question, and (iv), for debt securities, whether the Company intends to sell such securities. In addition, the authoritative guidance requires that OTTI for certain asset backed and mortgage backed securities are recognized if the fair value of the security is less than its discounted cash flow value and there has been a decrease in the present value of the expected cash flows since the last reporting period. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to discounted cash flow and a portion of the previously unrealized loss is therefore realized in the period such determination is made.
From April 1, 2009, in instances in which the Company determines that a credit loss exists but the Company does not intend to sell the security and it is not more likely than not that the Company will be
(g) Other Than Temporary Impairments (“OTTI”) of Available for Sale and Held to Maturity Securities (Continued)
The Company uses derivative instruments, primarily interest rate swaps, to manage the interest rate exposure associated with certain assets and liabilities. These derivatives are recorded at fair value. On the date the derivative contract is entered into, the Company may designate the derivative as a hedge of the fair value of a recognized asset or liability (“fair value” hedge); a hedge of the variability in cash flows of a forecasted transaction or of amounts to be received or paid related to a recognized asset or liability (“cash flow” hedge); or a hedge of a net investment in a foreign operation; or the Company may not designate any hedging relationship for a derivative contract. In addition, the Company previously wrote a number of resettable strike swaps contracts relating to an absolute return index and diversified basket of funds which are recorded within Investment Related Derivatives - Financial Market Exposures.
Changes in the fair value of a derivative that is designated and qualifies as a cash flow hedge are recorded in accumulated other comprehensive income (“AOCI”) and are reclassified into earnings when the variability of the cash flow of the hedged item impacts earnings. Gains and losses on derivative contracts that are reclassified from AOCI to current period earnings are included in the line item in the consolidated statements of operations in which the cash flows of the hedged item are recorded. Any hedge ineffectiveness is recorded immediately in current period earnings as “net realized and unrealized gains and losses on derivative instruments.” Periodic derivative net coupon settlements are recorded in net investment income. The Company may designate cash flow hedging relationships where interest rate swaps are used to mitigate interest rate risk associated with anticipated issuances of debt or other forecasted transactions.
Changes in fair value of a derivative used as a hedge of a net investment in a foreign operation, to the extent effective as a hedge, are recorded in the foreign currency translation adjustments account within AOCI. Cumulative changes in fair value recorded in AOCI are reclassified into earnings upon the sale or complete or substantially complete liquidation of the foreign entity. Any hedge ineffectiveness is recorded immediately in current period earnings as “net realized and unrealized gains and losses on derivative instruments.”
The Company discontinues hedge accounting prospectively when it is determined that the derivative is no longer highly effective in offsetting changes in the fair value or cash flows of a hedged item; the
derivative is dedesignated as a hedging instrument; or the derivative expires or is sold, terminated or exercised. When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an effective fair-value hedge, the derivative continues to be carried at fair value on the balance sheet with changes in its fair value recognized in current period earnings through “net realized and unrealized gains and losses on derivative instruments.” When hedge accounting is discontinued because the Company becomes aware that it is not probable that the forecasted transaction will occur, the derivative continues to be carried on the balance sheet at its fair value, and gains and losses that were accumulated in AOCI are recognized immediately in earnings.
The Company adopted authoritative guidance on the fair value recognition provisions for accounting for stock-based compensation, under the prospective method for options granted subsequent to January 1, 2003. Prior to 2003, the Company accounted for options under the disclosure-only provisions of the guidance and no stock-based employee compensation cost was included in net income as all options granted
In July 2010, the FASB amended the general accounting principles for receivables as they relate to the disclosures about the credit quality of financing receivables and the allowance for credit losses. This amendment requires additional disclosures that provide a greater level of disaggregated information about the credit quality of financing receivables and the allowance for credit losses. It also requires the disclosure of credit quality indicators, past due information, and modifications of financing receivables. The new disclosures are required for interim and annual periods ending after December 15, 2010, although the disclosures of reporting period activity (i.e., allowance roll-forward and modification disclosures) are required for interim and annual periods beginning after December 15, 2010. This standard affects disclosures only and, accordingly, did not have an impact on the Company’s financial condition or results of operations. See Note 10, “Other Investments,” and Note 12, “Reinsurance,” for disclosures provided related to this guidance.
The following tables set forth the Company’s assets and liabilities that were accounted for at fair value as of December 31, 2010 and December 31, 2009 by level within the fair value hierarchy (for further information, see Note 2 (b), “Significant Accounting Policies - Fair Value Measurements”:
Short-term investments consist primarily of Corporate, U.S. Government and Government-Related/Supported securities and Non-U.S. Sovereign Government, Supranational and Government-Related securities.
The derivative balances included in each category above are reported on a gross basis by level with a netting adjustment presented separately in the “Collateral and Counterparty Netting” column. The Company often enters into different types of derivative contracts with a single counterparty and these contracts are covered under a netting agreement. In addition, the Company held net cash collateral related to derivative assets of approximately $23.0 million and $169.1 million at December 31, 2010 and December 31, 2009, respectively. This balance is included within cash and cash equivalents and the corresponding liability to return the collateral has been offset against the derivative asset within the balance sheet as appropriate under the netting agreement. The fair value of the individual derivative contracts are reported gross in their respective levels based on the fair value hierarchy.
There were no transfers between Level 1 and Level 2 during the twelve month periods ended December 31, 2010 and 2009.
During the year ended December 31, 2010, certain CDOs that were previously classified as Level 2 due to sufficient market data being available to allow a price to be determined and provided by third party pricing vendors, were transferred to Level 3 because third party vendor prices were no longer believed to be the most appropriate pricing source. Broker quotes, for which sufficient information regarding the specific inputs utilized by the broker was not available to support a Level 2 classification, are the primary source of the valuations for these CDO securities.
At December 31, 2009, certain assets which were previously classified as Level 3 assets due to a lack of observable market data are now classified as Level 2 assets as described further below.
Included within the Other investments component of the Company’s Level 3 valuations are private investments and alternative investments where the Company is not deemed to have significant influence over the investee. The fair value of these investments is based upon net asset values received from the investment manager or general partner of the respective entity. The underlying investments held by the investee that form the basis of the net asset value include assets such as private business ventures that require the use of significant Level 3 inputs in the determination of the individual underlying holding values and accordingly the fair value of the Company’s investment in each entity is classified within Level 3. The Company also incorporates factors such as the most recent financial information received, the values at which capital transactions with the investee take place, and management’s judgment regarding whether any adjustments should be made to the net asset value in recording the fair value of each position. Investments in private equity and alternative funds included in Other investments utilize strategies including Arbitrage, Directional, Event Driven and Multi-style. These funds potentially have lockup and gate provisions which may limit redemption liquidity.
Derivative instruments classified within Level 3 include: (i) certain interest rate swaps where the duration of the contract the Company holds exceeds that of the longest term on a market observable input, (ii) guaranteed minimum income benefits (“GMIB”) embedded within a certain reinsurance contract, (iii) a put option included within the Company’s remaining contingent capital facility and (iv) credit derivatives sold providing protection on senior tranches of structured finance transactions where the value is obtained directly from the investment bank counterparty for which sufficient information regarding the inputs utilized in the valuation was not obtained to support a Level 2 classification. The majority of inputs utilized in the
valuations of these types of derivative contracts are considered Level 1 or Level 2; however, each valuation includes at least one Level 3 input that was significant to the valuation and, accordingly, the values are disclosed within Level 3.
The Company historically participated in structured transactions which included cash loans supporting project finance transactions and providing liquidity facility financing to structured project deals and the Company also invested in a payment obligation with an insurance company. These transactions are carried at amortized cost. The fair value of these investments held by the Company is determined through use of internal models utilizing reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data.
The fair value of the Company’s redeemable Series C preference ordinary shares outstanding is determined based on indicative quotes provided by brokers.
As at December 31, 2007, the Company had approximately $4.0 billion of deposit liabilities associated with guaranteed investment contracts (“GICs”) for which credit enhancement was provided by Syncora Guarantee. Based on the terms and conditions of the underlying GICs, upon the downgrade of Syncora Guarantee below certain ratings levels, all or portions of the outstanding principal balances on such GICs would come due. Throughout 2008, several rating agencies downgraded Syncora and its subsidiaries and as a result, the Company settled all of the GIC liabilities during 2008.
The Master Agreement provided for the payment by the Company to Syncora of $1.775 billion in cash, the issuance by the Company to Syncora of eight million of its ordinary shares which were newly issued by the Company and the transfer by the Company of all of its voting, economic or other rights in the shares it owned in Syncora (representing approximately 46% of Syncora’s issued and outstanding shares) (the “Syncora Shares”) to an escrow agent in accordance with an escrow agreement between Syncora and the Counterparties. This consideration was made in exchange for, among other things, the full and unconditional:
commutation of the Second Amended and Restated Facultative Master Certificate, effective March 1, 2007, pursuant to which XL Re America, Inc. (“XLRA”) agreed to reinsure certain liabilities of Syncora Guarantee, and all individual risk cessions thereunder; (the “XLRA Master Facultative Agreement”);
The Company and Syncora obtained approval from the New York State Insurance Department for the Master Agreement and each of the commutations to which XLRA or Syncora Guarantee was a party. Syncora also complied with all applicable procedures of the Bermuda Monetary Authority, the Delaware Insurance Department and other regulators.
The terms of the Master Agreement were determined in consideration of a number of commercial and economic factors associated with all existing relationships with Syncora, including, but not limited to, a valuation of the consideration for the commuted agreements and any potential future claims thereunder and the impact of outstanding uncertainty on both the ratings and business operations of the Company. The total
Pursuant to the terms of the Master Agreement, Syncora was required to use commercially reasonable efforts to commute the agreements that were the subject of the Company’s guarantee of Syncora Guarantee’s obligations under certain financial guarantees issued by Syncora Guarantee to the European Investment Bank (the “EIB Policies”), subject to certain limitations.
On June 28, 2010, the Company’s subsidiary, XL Insurance (Bermuda) Ltd (“XLI”), completed a commutation, termination and release agreement (the “Termination Agreement”) with EIB which fully extinguished and terminated all of the guarantees issued to EIB by XLI in connection with financial guaranty policies between certain subsidiaries of Syncora and EIB. Under the Termination Agreement, XLI paid $38 million to EIB, and all of XLI’s exposures under the EIB guarantees, with aggregate par outstanding of approximately $900 million, were eliminated. In addition, a further $0.5 million was paid to EIB for expenses in relation to the termination. Pursuant to the obligations of Syncora under the Master Agreement, Syncora paid XLI $15.0 million. The net cost of this transaction is reflected in the Company’s Consolidated Statement of Income as “Loss on Termination of Guarantee.”
The total cumulative costs the Company incurred in connection with these restructuring initiatives through their completion at December 31, 2009 were as follows:
The net results from P&C and Corporate structured products includes net investment income, interest expense and operating expenses of $110.7 million, $72.8 million, and $27.0 million, and $100.4 million, $72.6 million and $9.7 million, respectively.
Represents debt extinguishment costs associated with the early redemption of the Guaranteed Senior 6.58% Notes due 2011.
The following table presents 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, 2010, 2009 and 2008:
The Company has goodwill of $822.2 million as at December 31, 2010, of which $426.3 million relates to the Company’s Insurance segment while $395.9 million relates to the Company’s Reinsurance segment. The estimated fair values of these reporting units exceeded their net book values as of December 31, 2010 and therefore no impairments were recorded during 2010. There were no goodwill impairment charges recorded by the Company in any year prior to the amount recorded during 2008, as described further below. Therefore, the opening goodwill balance of $1.8 billion as at December 31, 2007 represents the gross balance of goodwill recorded by the Company. At December 31, 2010 and 2009, the ending goodwill balance is comprised of gross goodwill of $1.8 billion offset by accumulated impairment charges of $990 million.
The Company completed its annual goodwill impairment testing, as of June 30, 2010, June 30, 2009 and June 30, 2008, which did not result in any goodwill impairments. The results of the annual impairment tests were revisited at each respective year end to confirm that no impairments were required. As at June 30, 2010, 2009 and 2008, estimated fair values exceeded the related net book values of the respective units carrying goodwill. However, at December 31, 2008, due to the financial market and economic events that occurred in the fourth quarter of fiscal 2008, the Company’s interim impairment testing resulted in a non-cash goodwill impairment charge of $990.0 million. The charge related primarily to certain reinsurance unit goodwill associated with the merger of Mid Ocean Ltd. (“Mid Ocean”) in 1998.
Included within Corporate are certain medium term notes supported primarily by pools of European credit with varying degrees of leverage. The notes have a fair value of $454.8 million and an amortized cost of $504.6 million. These notes allow the investor to participate in cash flows of the underlying bonds including certain residual values, which could serve to either decrease or increase the ultimate values of these notes.
At December 31, 2010 and December 31, 2009, approximately 3.5% and 3.6%, respectively, of the Company’s fixed income investment portfolio at fair value was invested in securities which were below investment grade or not rated. Approximately 29.4% and 30.1% of the gross unrealized losses in the
Company’s fixed income securities portfolio at December 31, 2010 and 2009, respectively, related to securities that were below investment grade or not rated.
The following is an analysis of how long each of those available for sale securities at December 31, 2009 had been in a continual unrealized loss position:
The contractual maturities of available for sale fixed income securities are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Included in the table above are Tier One and Upper Tier Two securities, representing committed term debt and hybrid instruments senior to the common and preferred equities of the financial institutions, at their fair value of $757.8 million and $904.3 million at December 31, 2010 and December 31, 2009, respectively. These securities have been distributed in the table based on their call date and have net unrealized losses of $143.7 million and $225.2 million at December 31, 2010 and December 31, 2009, respectively.
Management, in its assessment of whether securities in a gross unrealized loss position are temporarily impaired, considers the significance of the impairments. The Company had structured credit securities with gross unrealized losses of $83.5 million, with a fair value of $43.0 million, which as at December 31, 2010 were impaired by greater than 50% of amortized costs. All of these are asset-backed securities. Of these gross unrealized losses, $10.2 million are rated investment grade. The Company in conjunction with its investment manager service providers, undertook a security level review of these securities and recognized charges to the extent it believed the discounted cash flow value of any security was below its amortized cost. These securities include gross unrealized losses of $51.6 million on non-Agency RMBS, $27.6 million of Core CDOs and $3.9 million of CMBS holdings.
For equities, the Company recorded impairments of $0.8 million for the year ended December 31, 2010.
For the year ended December 31, 2009, included in the above totals is $160.6 million related to changes to intent-to-hold up to March 31, 2009, or intent to sell from April 2009, primarily representing exchanges of hybrid securities, and as part of the fourth quarter 2008 change in intent to hold.
During the fourth quarter of 2008, management recorded a charge for OTTI of $400.0 million on assets with a fair value of $1.0 billion for which it could no longer assert its intent to hold until recovery. Although management believed that these securities were likely to recover to their current amortized cost, it determined that these securities were at risk for further mark-to-market declines, and potentially real economic losses, to the extent that economic conditions were to deteriorate further than the then present estimates and the Company’s allocation to these asset classes is overweight relative to a traditional P&C investment portfolio. Accordingly, in conjunction with its risk reduction exercise, management pursued targeted sales of these assets over the course of 2009. The assets were concentrated in certain holdings within the Company’s BBB and lower corporate, CMBS, equity and consumer ABS portfolios.
As discussed in Note 2, a portion of certain OTTI losses on fixed income securities and short-term investments are recognized in “Other comprehensive income (loss)” (“OCI”). Under final authoritative accounting guidance effective April 1, 2009, other than in a situation in which the Company has the intent to sell a security or more likely than not will be required to sell a security, the amount of the OTTI related to a credit loss is recognized in earnings, and the amount of the OTTI related to other factors (i.e., interest rates, market conditions, etc.) is recorded as a component of other comprehensive income (loss). The net amount recognized in earnings (“credit loss impairments”) represents the difference between the amortized cost of the security and the net present value of its projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment. Any remaining difference between the fair value and amortized cost is recognized in OCI. The following table sets forth the amount of credit loss impairments on fixed income securities held by the Company as of the dates indicated, for which a portion of the OTTI loss was recognized in OCI, and the corresponding changes in such amounts.
The determination of credit losses is based on detailed analyses of underlying cash flows. Such analyses require the use of certain assumptions in developing the estimated performance of underlying collateral. Key assumptions used include, but are not limited to, items such as, RMBS default rates based on collateral duration in arrears, severity of losses on default by collateral class, collateral reinvestment rates and expected future general corporate default rates.
The following represents an analysis of net realized gains (losses) and the change in unrealized (losses) gains on investments:
The Company had gross unrealized losses at December 31, 2010 and 2009, totaling $24.7 million and $15.7 million, respectively, on the above held to maturity income securities which it considered to be temporarily impaired as these holdings are predominantly highly rated quality government holdings and the loss has only arisen due to an interest rate increase in U.K. sterling and Euro currency.
The Company’s equity investment in investment fund affiliates and equity in net income (loss) from such affiliates as well as certain summarized financial information of the investee as a whole are included below:
Throughout 2008 and up until the closing of the Master Agreement in August 2008 which resulted in the transfer by the Company of all of the shares it owned in Syncora, the Company reported its investment in Syncora at nil which was less than the traded market value during this time, as it was believed the decline in value was other than temporary. In addition to the transfer of the Company’s shares it owned in Syncora as described above, under the Master Agreement, the Company paid consideration to Syncora of $1.775 billion cash as well as eight million ordinary shares valued at $128.0 million. The Master Agreement terminated certain reinsurance and service agreements with Syncora and as a result, related guarantee agreements with Syncora, with the exception of certain exposures relating to the European Investment Bank, no longer had any force or effect. As the total value of the consideration paid to Syncora significantly exceeded the liabilities related to such reinsurances and guarantees, the Company recorded a loss of approximately $1.4 billion, in “net (loss) income from operating affiliates,” in respect of the closing of the Master Agreement in the third quarter of 2008. See Note 4, “Syncora Holdings Ltd, (“Syncora”)” for further details. The Company’s other strategic operating affiliates at December 31, 2010 and 2009 included an investment in ARX Holding Corporation of 45.7% and 45.9%, respectively. The Company’s 49.9% investment in the Brazilian joint venture ITAU XL Seguros Corporativos S.A. (“ITAU”) was sold during the second quarter of 2010.
The Company records its operating affiliates on a one quarter lag. Estimated assets and liabilities are generally at September 30, 2010.
See Note 19(c), “Commitments and Contingencies - Investments in Affiliates,” for further information regarding commitments related to investment in affiliates.
Certain funds have a lock-up period. A lock-up period refers to the initial amount of time an investor is contractually required to invest before having the ability to redeem. Funds that do provide for periodic redemptions may, depending on the funds’ governing documents, have the ability to deny or delay a redemption request, called a gate, or suspend redemptions as a whole. The fund may implement this restriction because the aggregate amount of redemption requests as of a particular date exceeds a specified level, generally ranging from 15% to 25% of the fund’s net assets. The gate is a method for executing an orderly redemption process that reduces the possibility of adversely affecting the remaining investors in the fund in the event of substantial redemption requests falling on a single redemption date. Typically, the imposition of a gate delays a portion of the requested redemption, with the remaining portion settled in cash shortly after the redemption date.
As these alternative and private investments included in other investments do not pay dividends, income is realized only on partial or ultimate sale of these investments. The Company had net unrealized gains of $86.1 million and $51.9 million, respectively, at December 31, 2010 and 2009, related to alternative investments. On sales related to the alternative investments, the Company had realized gains of $0.5 million and $21.8 million in 2010 and 2009, respectively, with realized losses of $13.1 million in 2008. For private investments, the company had net unrealized gains of $18.1 million and $6.9 million, at December 31, 2010 and 2009, respectively, and realized gains of $3.0 million for the year ended December 31, 2010, and nil for the years ended December 31, 2009 and 2008.
The outstanding payment obligation was recorded in Other Investments at an estimated fair value of $128.1 million, pays a coupon of 3.5%, and will be accreted to $150 million over the 11.5 year term of the payment obligation. The difference between the estimated fair value of the Obligation and the cost of that Obligation at the time of the transaction was approximately $21.9 million and is recorded in Other Assets. This difference is being amortized in relation to the earning of the underlying policies written. During the years ended December 31, 2010 and 2009, amortization of $9.5 million and $5.5 million, respectively, was recorded.
As described in Note 2(r), “Significant Accounting Policies - Recent Accounting Pronouncements,” the Company has investments in senior tranches of Synthetic CDOs as well as certain CDO Squared structures, which in turn hold Synthetic CDOs that were required to be evaluated for embedded credit derivatives at July 1, 2010. Investments in these securities were entered into in the normal course of portfolio investing and were considered from a risk management perspective to be consistent with traditional asset backed security (“ABS”) CDOs. While the performance of the underlying securitized credit exposures varies, in management’s judgment, the contractual subordination within the securitized interest is sufficient to absorb the current expected losses.
The Company regularly reviews the performance of these other investments. The Company recorded losses of $7.8 million, $0.9 million and $1.5 million in the years ended December 31, 2010, 2009 and 2008, respectively, due to other than temporary declines in values of these other investments.
Does not include changes in losses incurred related to previous facultative and excess of loss reinsurance of Syncora as such changes are included in “Net loss from operating affiliates.”
During 2010, net favorable prior year development totaled $372.9 million in the Company’s property and casualty operations and included net favorable development in the Insurance and Reinsurance segments of $127.4 million and $245.4 million, respectively.
Net favorable prior year reserve development for the Insurance segment of $127.4 million for the year ended December 31, 2010 was mainly attributable to the following:
For casualty lines, net prior year development during the year was $13.4 million unfavorable due mainly to a $45.1 million strengthening in the North American risk management lines, where there has been higher than expected actual losses and reserve assumptions have been revised to give greater weight to actual experience relative to industry benchmarks. The unfavorable development was partially offset by a $26.0 million decrease in the uncollectible reinsurance reserve from reduced exposures and lower estimated risk levels from the Swiss operations. On a gross basis, the excess casualty lines have experienced higher than expected actual losses which have only been partially offset by lower than expected actual losses in the primary casualty lines. However, the gross deterioration in excess casualty was heavily ceded so that on a net basis the strengthening in excess casualty has been almost entirely offset by the release in primary casualty.
For professional lines, net prior year development was $118.6 million favorable. This was driven by lower than expected actual losses in the Hartford Standard ($89.8 million mainly from report years 2007 and prior) and International ($41.1 million in report year 2006) lines, favorable reserve development in Bermuda errors and omissions lines ($57.2 million for report years 2003 and prior), and favorable Clash development ($28.2 million from report years 2006 and prior). This was partially offset by higher than expected actual losses in the Hartford Private Commercial lines ($63.7 million), and in the small to midsize professional services lines, in particular in the miscellaneous professionals ($21.8 million), architects and engineers ($6.2 million), and real estate ($5.5 million) books.
For specialty and other lines, net prior year development was $2.1 million unfavorable due mainly to an unfavorable settlement in the surety lines ($40.4 million), higher than expected actual losses in the environmental lines ($15.5 million), and an unfavorable commutation in the financial lines ($9.1 million). This was mostly offset by lower than expected actual losses in the aerospace ($32.9 million), marine ($7.2 million), specie ($5.5 million) and equine ($3.1 million) lines as well as a reduction in the provision for unrecoverable reinsurance due to reduced exposures and lower estimated risk levels from the London Market operations ($13.1 million).
Net favorable prior year reserve development for the Insurance segment of $62.9 million for the year ended December 31, 2009 was mainly attributable to the following:
For property and casualty lines, reserve releases in certain casualty lines primarily in 2003 to 2006 accident years due to lower than expected reported loss activity and favorable reserve development in global property lines of business as a result of favorable claim development. In addition, net reserve releases resulted from an agreement with Axa/Winterthur of approximately $80.9 million in the fourth quarter of 2008 in regards to certain reinsurance recoverable balances relating to casualty lines and to a lesser extent, certain property lines of business.
For specialty lines, modest reserve strengthening within specialty lines, primarily in the environmental lines of business, as well as strengthening associated with certain structured indemnity contracts.
Gross prior year favorable development for the year ended December 31, 2008 of $609.6 million exceeded the corresponding net favorable development during the same period of $305.5 million. The impact of reductions in gross reported losses on older years in certain casualty lines was mostly offset by the impact of the reinsurance recoverable component on such losses. The impact of gross reserve releases in professional and specialty lines was mostly offset by the impact of a reduction in estimated ceded IBNR following a reserve review in these lines.
Net favorable prior year reserve development for the Reinsurance segment of $245.5 million for the year ended December 31, 2010 was mainly attributable to the following:
$7.5 million in marine and aviation lines due to lower than expected claim emergence in the European marine book for underwriting years 2007 and 2008 offset by minimal net reserve increases on the aviation book.
$21.0 million in favorable casualty development related primarily to the European General Liability and UK Motor portfolios in underwriting years 2004 to 2007.
$40.7 million in favorable professional development due primarily to U.S. exposures for underwriting years 2002 and prior in addition to professional indemnity exposures for European underwriting years 2006 and prior.
Gross prior year favorable development for the year ended December 31, 2008 of $444.3 million exceeded the corresponding net favorable development during the same period of $305.2 million as the impact of favorable loss experience related to a large crop program was mostly offset by the impact of retrocession protection related to this program.
The Company did not dispose of or acquire net loss reserves in 2010, 2009 or 2008.
The Company’s net unpaid losses and loss expenses included estimates of actual and potential non-recoveries from reinsurers. As at December 31, 2010 and 2009, the reserve for potential non-recoveries from reinsurers was $121.9 million and $189.8 million, respectively.
With respect to financial guarantee exposures, the amount of case basis reserve is based on the net present value of the expected ultimate loss and loss adjustment expense payments that the Company expects to make, net of expected recoveries under salvage and subrogation rights. Case basis reserves are determined using cash flow or similar models to estimate the net present value of the anticipated shortfall between (i) scheduled payments on the insured obligation plus anticipated loss adjustment expenses and (ii) anticipated cash flow from the proceeds to be received on sales of any collateral supporting the obligation and other anticipated recoveries.
The Company utilizes tabular reserving for workers’ compensation (including long-term disability) unpaid losses that are considered fixed and determinable, and discounts such losses using an interest rate of 5% in 2010 and 2009. The interest rate approximates the average yield to maturity on specific fixed income investments that support these liabilities. The tabular reserving methodology results in applying uniform and consistent criteria for establishing expected future indemnity and medical payments (including an explicit factor for inflation) and the use of mortality tables to determine expected payment periods. Tabular unpaid losses and loss expenses, net of reinsurance, at December 31, 2010 and 2009 on an undiscounted basis were $660.3 million and $734.1 million, respectively. The related discounted unpaid losses and loss expenses were $311.9 million and $343.7 million as of December 31, 2010 and 2009, respectively.
Reserves for incurred but not reported losses, net of reinsurance, included in the above table were $54.9 million, $68.5 million and $73.5 million in 2010, 2009 and 2008, respectively. Unpaid losses recoverable are net of potential uncollectible amounts.
The Company recorded reinsurance recoveries on losses and loss expenses incurred of $1.0 billion, $0.8 billion and $0.7 billion for the years ended December 31, 2010, 2009 and 2008, respectively. Included in the figure noted above in 2008 was profit of approximately $80.9 million related to an agreement entered into with AXA/Winterthur. For further information see “AXA Agreement” below.
At December 31, 2010 and 2009, the total reinsurance assets of $3.8 billion and $4.0 billion respectively, included reinsurance receivables for paid losses and loss expenses of $171.3 million and $374.8 million, respectively, with $3.7 billion and $3.6 billion respectively, relating 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 the Company has 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 its ability to meet these obligations and while it may continue to acknowledge its contractual obligation to do so, it may not have the financial resources or willingness to fully meet its obligations to the Company.
At December 31, 2010 and 2009, the allowance for uncollectible reinsurance relating to both reinsurance balances receivable and unpaid losses and loss expenses recoverable were $121.9 million and $189.8 million, respectively. To estimate the provision for uncollectible reinsurance recoverable, the reinsurance recoverable must first be allocated to applicable reinsurers. 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.
Approximately 90% of the total unpaid loss and loss expense recoverable and reinsurance balances receivable (excluding collateral held) outstanding at December 31, 2010 was due from reinsurers with a
financial strength rating of “A” or better. The following is an analysis of the total recoverable and reinsurance balances receivable at December 31, 2010, by reinsurers owing more than 3% of such total:
than was originally agreed. In return, the Company released AXA, subject to certain exceptions, from the SPA, as amended, between the Company and AXA, and commuted AXA’s share of various reinsurance contracts where AXA reinsured subsidiaries of the Company relating to certain parts of the Winterthur Business. In addition, the Company and AXA reached a definitive claims handling agreement governing defined Excluded Winterthur Business, including asbestos claims and business written prior to 1986, which remain the financial responsibility of AXA. In connection with the execution of the AXA Agreement and the adjustment of related provisions, the Company recorded income of approximately $80.9 million in 2008, which was recorded as favorable net prior year development within the Company’s Insurance segment.
normal releases on single premium annuities in line with benefits paid and mortality of underlying policyholders.
As at December 31, 2010 and 2009, the Company had bank and loan facilities available from a variety of sources, including commercial banks, totaling $3.5 billion and $3.6 billion, respectively, of which $2.4 billion and $2.4 billion, respectively, of debt was outstanding. In addition, at December 31, 2010 and 2009, the Company had available letter of credit facilities totaling $5.0 billion and $7.3 billion, respectively, of which $2.4 billion and $3.0 billion, respectively, were outstanding as at December 31, 2010 and 2009, 21.1% and 21.3%, respectively, of which were collateralized by certain of the Company’s investment portfolios, primarily supporting U.S. non-admitted business and the Company’s Lloyd’s syndicates’ capital requirements. Of these amounts, $1.0 billion was available in the form of revolving credit.
“In Use” and “Outstanding” data represent December 31, 2009 accreted values.
All outstanding debt noted in the table above as at December 31, 2010 and 2009 was issued by XL-Cayman except for the $600 million par value 6.5% Guaranteed Senior Notes due January 2012 which were issued by XL Capital Finance (Europe) plc (“XLCFE”). Both XL-Cayman and XLCFE are wholly owned subsidiaries of XL-Ireland. These notes are fully and unconditionally guaranteed by XL Company Switzerland GmbH. The Company’s ability to obtain funds from its subsidiaries to satisfy any of its obligations under this guarantee is subject to certain contractual restrictions, applicable laws and statutory requirements of the various countries in which the Company operates including among others, Bermuda, the U.S., Ireland and the U.K. Required statutory capital and surplus for the principal operating subsidiaries of the Company was $6.2 billion as of December 31, 2010.
Concurrent with the issuance of ordinary shares and pursuant to the Company’s shelf registration statement, the Company, in August 2008, issued 23.0 million 10.75% Equity Security Units (the “10.75% Units”) in a public offering in order to fund payments described above in relation to the Master Agreement and remaining net proceeds were used for general corporate purposes. The Company received approximately $557.0 million in net proceeds from the sale of the 10.75% Units after deducting underwriting discounts. Each 10.75% Unit has a stated amount of $25 and consists of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s Ordinary Shares on August 15, 2011 and (b) a one-fortieth, or 2.5%, ownership interest in a senior note issued by the Company due August 15, 2021 with a principal amount of $1,000. The senior notes are pledged by the holders to secure their obligations under the purchase contract.
The number of shares issued under the purchase contract is contingently adjustable based on, among other things, the share price of the Company on the stock purchase date and the dividend rate of the Company. The Company will make quarterly payments at the annual rate of 2.50% and 8.25% under the purchase contracts and senior notes, respectively. For all periods reported, the Company may defer the contract payments on the purchase contract, but not the senior notes, until the stock purchase date. In August 2011, the senior notes will be remarketed whereby the interest rate on the senior notes will be reset in order to generate sufficient remarketing proceeds to satisfy the 10.75% Unit holders’ obligations under the purchase contracts. If the senior notes are not successfully remarketed, then the Company will exercise
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 on the settlement date. The maximum number of ordinary shares to be issued under the purchase contracts is approximately 35.9 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 10.75% 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 $18.88 per share. Because the average market price of the Company’s ordinary shares during the period the 10.75% 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 year ended December 31, 2009.
In December 2005, the Company issued 29.8 million 7.0% Equity Security Units (the “7.0% Units”) in a public offering. Each 7.0% Unit had a stated amount of $25 and consisted of (a) a purchase contract pursuant to which the holder agreed to purchase, for $25, a variable number of shares of the Company’s ordinary shares on February 15, 2009 and (b) a one-fortieth, or 2.5% in the 2011 Senior Notes. The 2011 Senior Notes were pledged by the holders to secure their obligations under the purchase contracts. The number of shares issued under the purchase contracts was adjustable based on, among other things, the average share price of the Company for the twenty consecutive trading days ending on the third trading day immediately preceding the stock purchase date and the dividend rate of the Company. In mid-February 2009, the 2011 Senior Notes were remarketed whereby the interest rate was reset in order to generate sufficient remarketing proceeds to satisfy the 7.0% Unit holders’ obligations under the purchase contracts. The Company purchased and retired the aggregate principal amount of the 2011 Senior Notes as a part of that remarketing. On February 15, 2009, the purchase contracts matured and the Company issued ordinary shares in connection therewith. Each purchase contract provided for the sale by the Company of 0.38461 ordinary shares (the “Shares”) at a price of $25.00. The settlement of the purchase contracts resulted in the Company’s issuance of an aggregate of 11,461,080 Shares for net proceeds of approximately $743.1 million, which was used to retire the 2011 Senior Notes.
Under the Company’s five-year credit facility, in the event that XL Capital Group, XL Insurance (Bermuda) Ltd and XL Re Ltd fail to maintain a financial strength rating of at least “A-” from A.M. Best, an event of default would occur.
Financial operations derivatives represent interests in variable interest entities as described in Note 18, “Variable Interest Entities.”
On June 7, 2010, the Company settled the interest rate contracts designated as fair value hedges of certain issues of the Company’s notes payable and debt. The derivative contracts were settled for a gain of $21.6 million. The cumulative increase recorded to the carrying value of the hedged notes payable and debt, representing the effective portion of the hedging relationship, will be amortized through interest expense over the remaining term of the debt. From the date of settlement through December 31, 2010, $3.9 million of the balance was recorded as a reduction of interest expense. The remaining balance of $17.7 million will be amortized over the weighted average period of 3.2 years remaining to maturity of the debt.
On October 27, 2010, the Company settled three interest rate contracts designated as fair value hedges of certain of the Company’s deposit liability contracts. The derivative contracts were settled for a gain of $149.5 million. The cumulative increase recorded to the carrying value of the deposit liability, representing the effective portion of the hedging relationship, will be amortized through interest expense over the remaining term of the deposit liability contracts. From the date of settlement through December 31, 2010, $1.9 million of the balance was recorded as a reduction of interest expense. The remaining balance of $147.6 million will be amortized over the weighted average period of 36.3 years remaining on these deposit contracts.
The periodic coupon settlements also resulted in decreases to interest expense of $49.8 million and $20.1 million for years ended December 31, 2010 and 2009, respectively.
The following table provides the total impact on earnings relating to derivative instruments not formally designated as hedging instruments under authoritative accounting guidance. The impacts are all recorded through Net realized and unrealized gains (losses) on derivatives in the income statement for years ended December 31, 2010 and 2009:
Stock index futures may be purchased within the Company’s investment portfolio in order to create synthetic equity exposure and to add value to the portfolio with overlay strategies where market inefficiencies are believed to exist. The Company previously wrote a number of resettable strike swaps contracts relating to an absolute return index and diversified baskets of funds. From time to time, the Company may enter into other financial market exposure derivative contracts on various indices including, but not limited to, inflation and commodity contracts.
The Company held credit derivative exposures through a limited number of contracts written as part of the Company’s previous financial lines businesses, and through the Company’s prior reinsurance agreements with Syncora, as described below. Following the secondary sale of Syncora common shares, the Company retained some credit derivative exposures written by Syncora and certain of its subsidiaries through reinsurance agreements that had certain derivatives exposures embedded within them. The change in value of the derivative portion of the financial guarantee reinsurance agreements the Company had with Syncora was included in “Net (loss) income from operating affiliates.” Following the closing of the Master Agreement during August 2008, as described in Note 4, “Syncora Holdings Ltd,” which terminated certain reinsurance and other agreements, these credit derivative exposures were eliminated by virtue of the commutation of the relevant reinsurance agreements.
tests. As a result, both interest and principal proceeds are currently redirected to amortize the senior most notes, which reduces the Company’s exposure sooner than originally anticipated. Management continues to monitor its underlying performance and is comfortable with the collateral coverage. The European project finance loan participation benefits from an 80% deficiency guarantee from the German state and federal governments.
At December 31, 2010, there were no reported events of default on these obligations. Credit derivatives are recorded at fair values, which are determined using either models developed by the Company or third party prices and are dependent upon a number of factors, including changes in interest rates, future default rates, credit spreads, changes in credit quality, future expected recovery rates and other market factors. The change resulting from movements in credit and credit quality spreads is unrealized as the credit derivatives are not traded to realize this resultant value.
Certain derivatives agreements entered into by the Company or its subsidiaries contain rating downgrade provisions that permit early termination of the agreement by the counterparty if collateral is not posted following failure to maintain certain credit ratings from one or more of the principal credit rating agencies. If the Company were required to early terminate such agreements due to a rating downgrade, it could potentially be in a net liability position at time of settlement. The aggregate fair value of all derivatives agreements containing such rating downgrade provisions that were in a liability position on December 31, 2010 and 2009 was $25.9 million and $30.8 million, respectively. The Company has not been required to post collateral under any of these agreements as of December 31, 2010 or 2009, respectively.
At times, the Company has utilized VIEs both indirectly and directly in the ordinary course of the Company’s business.
passive in nature and we are not the arranger of these entities. The Company has not been involved in establishing these entities. The Company is not the primary beneficiary of these variable interest entities as contemplated in current authoritative accounting guidance.
In addition, the Company underwrites a significant amount of its insurance and reinsurance property and casualty business through brokers and a credit risk exists should any of these brokers be unable to fulfill their contractual obligations with respect to the payments of insurance and reinsurance balances to the Company. During the three years ended December 31, 2010, 2009 and 2008, approximately 21%, 18% and 17%, respectively, of the Company’s consolidated gross written premiums from property and casualty operations were generated from or placed by Marsh & McLennan Companies. During 2010, 2009 and 2008, approximately 21%, 20% and 19%, respectively, of the Company’s consolidated gross written premiums from property and casualty operations were generated from or placed by AON Corporation and its subsidiaries. During 2010, 2009 and 2008, approximately 11%, 9% and 9%, respectively, of the Company’s
consolidated gross written premiums from property and casualty operations were generated from or placed by The Willis Group and its subsidiaries. These companies are large, well established companies and there are no indications that any of them are financially troubled. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written from property and casualty operations in any of the three years ended December 31, 2010, 2009, or 2008.
The Company has committed to invest in several limited partnerships and provide liquidity financing to a structured investment vehicle. As of December 31, 2010, the Company has commitments which include potential additional add-on clauses, to fund a further $111.6 million.
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 $25.9 million over the next five years.
The Company rents space for certain of its offices under leases that expire up to 2031. Total rent expense under operating leases for the years ended December 31, 2010, 2009 and 2008 was approximately $31.8 million, $34.4 million and $35.4 million, respectively. Future minimum rental commitments under existing operating leases are expected to be as follows:
The Company is an Irish corporation and, except as described below, neither it nor its non-U.S. subsidiaries have paid U.S. corporate income taxes (other than withholding taxes on dividend income) on the basis that they are not engaged in a trade or business or otherwise subject to taxation in the U.S. However, because definitive identification of activities which constitute being engaged in a trade or business in the U.S. is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there can be no assurance that the Internal Revenue Service will not contend that the Company or its non-U.S. subsidiaries are engaged in a trade or business or otherwise subject to taxation in the U.S. If the Company or its non-U.S. subsidiaries were considered to be engaged in a trade or business in the U.S. (and, if the Company or such subsidiaries were to qualify for the benefits under the income tax treaty between the U.S. and Bermuda and other countries in which the Company operates, such businesses were attributable to a “permanent establishment” in the U.S.), the Company or such subsidiaries could be subject to U.S. tax at regular tax rates on its taxable income that is effectively connected with its U.S. trade or business plus an additional 30% “branch profits” tax on such income remaining after the regular tax, in which case there could be a significant adverse effect on the Company’s results of operations and financial condition.
The Company is subject to litigation and arbitration in the normal course of its business. These lawsuits and arbitrations principally involve claims on policies of insurance and contracts of reinsurance and are typical for the Company and for the property and casualty insurance and reinsurance industry in general. Such legal proceedings are considered in connection with the Company’s loss and loss expense reserves. Reserves in varying amounts may or may not be established in respect of particular claims proceedings based on many factors, including the legal merits thereof. In addition to litigation relating to insurance and reinsurance claims, the Company and its subsidiaries are subject to lawsuits and regulatory actions in the normal course of business that do not arise from or directly relate to claims on insurance or reinsurance policies. This category of business litigation typically involves, amongst other things, allegations of underwriting errors or misconduct, employment claims, regulatory activity, shareholder disputes or disputes arising from business ventures. The following information highlights ongoing legal proceedings related to the Company.
Sherman Act claims with prejudice and, by Opinion and Order dated September 28, 2007, the Court dismissed the RICO claims with prejudice. The plaintiffs then appealed both Orders to the U.S. Court of Appeals for the Third Circuit. On August 16, 2010, the Third Circuit affirmed in large part the District Court’s dismissal. The Third Circuit reversed the dismissal of certain Sherman Act and RICO claims alleged against several defendants including XL-Cayman and two of its subsidiaries but remanded those claims to the District Court for further consideration of their adequacy. In light of its reversal and remand of certain of the federal claims, the Third Circuit also reversed the District Court’s dismissal (based on the District Court’s declining to exercise supplemental jurisdiction) of the state-law claims against all defendants. On October 1, 2010 the remaining defendants including XL-Cayman and two of its subsidiaries filed motions to dismiss the remanded federal claims and the state-law claims. The motions have been fully briefed and await the District Court’s decision.
exposures are comprised of (i) $108.3 million notional financial guarantee on three notes backed by zero coupon bonds and bank perpetual securities; (ii) $47.5 million notional financial guarantee on a collateralized fund obligation with a collateral cushion in excess of 60% of the Company’s exposure that is currently being wound-up in an orderly manner and (iii) the remaining $49.0 million of financial guarantees is comprised of 33 separate transactions with varying forms of underlying collateral, including pre-2000 vintage asset backed securities and municipal government bonds. The underlying financial guarantees are diversified and not individually significant.
At December 31, 2009, the Company’s outstanding financial guarantee contracts included the reinsurance of 41 financial guarantee contracts with total insured contractual payments outstanding of $713.6 million ($568.2 million of principal and $145.4 million of interest) and having a remaining weighted-average contract period of 11.5 years. The total gross claim liability and unearned premiums recorded at December 31, 2009 were $14.5 million and $1.5 million, respectively. Of the contractual exposure existing at December 31, 2009, the Company had reinsured $423.8 million with subsidiaries of Syncora, however, at December 31, 2009, there were no gross claims liabilities or recoverables recorded. Of the 41 contracts noted above, three contracts with total insured contractual payments outstanding of $16.1 million had experienced an event of default and were considered by the Company to be non-performing at December 31, 2009, while the remaining 38 contracts were considered to be performing at such date.
On June 28, 2010, the Company’s subsidiary, XL Insurance (Bermuda) Ltd (“XLI”), completed a commutation, termination and release agreement (the “Termination Agreement”) with European Investment Bank (“EIB”) which fully extinguished and terminated all of the guarantees issued to EIB by XLI in connection with financial guaranty policies between certain subsidiaries of Syncora Holdings Ltd. (formerly Security Capital Assurance Ltd, “Syncora Holdings”) and EIB. These guarantees were provided for the benefit of EIB relating to project finance transactions comprised of transportation, school and hospital projects with an average rating of BBB, written between 2001 and 2006 with anticipated maturities ranging between 2027 and 2038. The guarantees had been accounted for under Accounting Standards Codification (“ASC”) section 460-10, Guarantees (previously FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.”)
The authorized share capital is 999,990,000 ordinary shares of par value $0.01 each, 40,000 ordinary shares of par value 1.00 each, 20,000,000 Redeemable Series C preference ordinary shares of par value $0.01 each, 350,000 Series D preference shares of par value $0.01 each, and 1,000,000 Series E preferable ordinary shares of par value $0.01 each. Holders of ordinary shares are entitled to one vote for each share.
As described in Note 15, “Notes Payable and Debt Financing Arrangements,” following the settlement of the purchase contracts associated with the 7.0% Units in February 2009, the Company issued 11,461,080 Shares for net proceeds of approximately $745.0 million, which was used to retire the 2011 Senior Notes.
Pursuant to the Company’s shelf registration statement, the Company issued 143.8 million ordinary shares in August 2008 at a price of $16.00 per share. The net proceeds from this issuance totaled approximately $2.2 billion. The proceeds were used to fund the payments made under the Master
Agreement as well as to redeem X.L. America’s $255 million 6.58% Guaranteed Notes as described in Note 15, “Notes Payable and Debt Financing.” In addition, proceeds were used for general corporate purposes and capital funding for certain of the Company’s subsidiaries.
The Company’s performance incentive programs provide for grants of stock options, restricted stock, restricted stock units and performance units and stock appreciation rights. Share based compensation granted by the Company generally contains a vesting period of three or four years, and certain awards also contain performance conditions. The Company records compensation expense related to each award over its vesting period incorporating the best estimate of the expected outcome of performance conditions where applicable. Compensation expense is generally recorded on a straight line basis over the vesting period of an award.
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price on the last trading day of the 2010 fiscal year and the exercise price, multiplied by the number of in-the-money-options) that would have been received by the option holders had all option holders exercised their options on December 31, 2010. Total unrecognized stock based compensation expense related to non-vested stock options was approximately $11.8 million as of the end of December 31, 2010, related to approximately 4.6 million options, which is expected to be recognized over a weighted-average period of 1.2 years. No options were exercised during 2008 or 2009. The exercise price of the Company’s outstanding options granted is the market price of the Company’s ordinary shares on the grant date, except that during 2004, 295,000 options were granted with an exercise price of $88.00 when the market price was $77.10.
During 2010, 2009, and 2008, the Company granted 62,577, 146,895 and 1,349,620 shares, respectively, of its restricted common stock to its directors and employees related to incentive compensation plans, with a weighted average grant date fair value per share of $17.26, $11.24 and $37.61, respectively. During the years ended December 31, 2010, 2009, and 2008, $18.4 million, $32.2 million and $57.6 million, respectively, was charged to compensation expense related to restricted stock awards. Total unrecognized stock based compensation expense related to non-vested restricted stock awards was approximately $8.9 million as of the end of December 31, 2010, related to approximately 0.5 million restricted stock awards, which is expected to be recognized over 0.9 years.
The Company’s Rights Plan expired in accordance with its terms on September 30, 2008. Rights to purchase ordinary shares (the “Rights”) were distributed as a dividend at the rate of one Right for each ordinary share held of record as of the close of business on October 31, 1998. Each Right entitled holders of ordinary shares to buy additional ordinary shares with a value of $700 at the then current market price, at an exercise price of $350. The Rights would have been exercisable, and would have detached from the ordinary shares, only if a person or group were to have acquired 20% or more of the Company’s outstanding ordinary shares, or were to have announced a tender or exchange offer that, if consummated, would have resulted in a person or group beneficially owning 20% or more of ordinary shares. Upon a person or group without prior approval of the Board acquiring 20% or more of ordinary shares, each Right would have entitled the holder (other than such an acquiring person or group) to purchase ordinary shares (or, in certain circumstances, ordinary shares of the acquiring person) with a value of twice the Rights exercise price upon payment of the Rights exercise price. The Company would have been entitled to redeem the Rights at $0.01 per Right at any time until the close of business on the tenth day after the Rights became exercisable.
A qualified non-contributory defined benefit pension plan exists to cover a number of its U.S. employees. This plan also includes a non-qualified supplemental defined benefit plan designed to compensate individuals to the extent that their benefits under the Company’s qualified plan are curtailed due to Internal Revenue Code limitations. Benefits are based on years of service and compensation, as defined in the plan, during the highest consecutive three years of the employee’s last ten years of employment. Under these plans, the Company’s policy is to make annual contributions to the plan that are deductible for federal income tax purposes and that meet the minimum funding standards required by law. The contribution level is determined by utilizing the entry age cost method and different actuarial assumptions than those used for pension expense purposes.
The fair value of the U.S. Plan assets at December 31, 2010 and 2009 was $25.1 million and $22.0 million, respectively. As both of the retirement plan’s investments are mutual funds, they fall within Level 1 in the fair value hierarchy.
The U.K. pension plan assets are held in a separate Trustee administered fund to meet long term liabilities to past and present employees. The table below shows the composition of the Plan’s assets and the fair value of each major category of plan assets as of December 31, 2010 and 2009, as well as the potential returns of the different asset classes. The total of the asset values held in various externally managed portfolios are provided by third party pricing vendors. There is no significant concentration of risk within plan assets.
Certain contributory defined benefit pension plans exist in several European countries, most notably Germany, which are closed to new entrants. Benefits are generally based on length of service and compensation defined in the related agreements. Included in the projected obligation amounts of $66.3 million and $57.0 million at December 31, 2010 and 2009, respectively, in the table below, are total unfunded projected obligations in relation to the European defined benefit schemes of $16.0 million and $14.3 million, respectively.
The components of the net benefit cost for the years ended December 31, 2010 and 2009 are as follows:
Following completion of the redomestication transaction, with effect from July 1, 2010, the Company is subject to income and capital gains tax in Ireland under applicable Irish law. Prior to July 1, 2010, the Company was resident for tax purposes in the Cayman Islands and in accordance with Cayman law, was not subject to any taxes in the Cayman Islands on either income or capital gains.
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 thereunder.
The Company adopted the provisions of the final authoritative guidance on accounting for uncertainty in income taxes, on January 1, 2007. The Company did not recognize any liabilities for unrecognized tax benefits as a result of its implementation and has not recognized any liabilities in subsequent accounting periods.
Significant components of the Company’s deferred tax assets and liabilities as of December 31, 2010 and 2009 were as follows:
Shareholders’ equity at December 31, 2010 and 2009 reflected tax benefits of nil and nil, respectively, related to compensation expense deductions for stock options exercised by the Company’s U.S. subsidiaries.
Certain statutory restrictions on the payment of dividends from retained earnings by the Company’s subsidiaries are further detailed below.
mathematical model that can relate more accurately the risks taken on by (re)insurers to the capital that is dedicated to their business. Insurers and reinsurers may adopt the BSCR model or, where an insurer or reinsurer believes that its own internal model better reflects the inherent risk of its business, an in-house model approved by the BMA. Class 4 (re)insurers, such as the Company, were required to implement the new capital requirements under the BSCR model beginning with fiscal years ending on or after December 31, 2009. The Company’s capital requirements under the BSCR are highlighted in the table above. In addition to the BSCR based requirements, the BMA also prescribes minimum liquidity standards which must be met.
Under the Insurance Act 1978, amendments thereto and related regulations of Bermuda, the Company’s Bermuda subsidiaries, XL Re Ltd and XL Insurance (Bermuda) Ltd, are prohibited from declaring or paying dividends of more than 25% of each of their prior year’s statutory capital and surplus unless the Company filed with the Bermuda Monetary Authority a signed affidavit by at least two members of the Company’s Board of Directors and the Company’s Principal Representative attesting that a dividend in excess of this amount would not cause the company to fail to meet its relevant margins is required. At December 31, 2010 and 2009, the maximum dividend that the Bermuda operating entities could pay, without a signed affidavit, having met minimum levels of statutory capital and surplus and liquidity requirements, was approximately $1.3 billion and $1.3 billion, respectively.
For the years ended December 31, 2010 and 2009, potential ordinary shares issued under share based compensation plans of 12.8 million and 12.3 million, respectively, were not included in the calculation of diluted earnings per share because the assumed exercise or issuance of such shares would be anti-dilutive.
For detailed information regarding the Company’s transactions with Syncora see Note 4, “Syncora Holdings Ltd.”